The biggest stock market news over the past few months has been what happened with GameStop. If you didn’t keep up with the story, we don’t blame you — even though it involved many novice investors, it wasn’t the easiest story to follow. Dodd Disler with Sagace Wealth will walk you through what happened with GameStop and what it might mean for your investment future.
What happened with the GameStop stock?
GameStop (GME) is primarily a brick-and-mortar retailer of new and used video games. Most gamers have transitioned to buying and playing games online, not buying discs at the mall as they once had, and as a result, GME sales and profits have been declining for several years.
This led a number of hedge funds to bet the stock value would decline. To make this bet, they “short” the stock. Let’s say you own 100 shares of GME. If I wanted to short, I would borrow the shares from you, and immediately sell them at the market price at say $10 per share. So I pocket $1,000 cash, but have an IOU to replace your 100 shares at a future date. Now let’s assume the stock goes down to $2 per share. I buy 100 shares in the open market for $200 and replace the shares I owe you. Just like that, I made a profit of $800.
At one point, 150% of the total outstanding shares of GME were sold short, meaning there were IOUs out for all the shares, and in some cases two IOUs for the same share. A group of astute retail investors on the message board Reddit noticed this and concluded that at some point these shorted shares would need to be bought to replace the IOUs.
Keep in mind, there is a limited supply of outstanding shares. The law of supply and demand states that when demand increases, the price must rise. Knowing this, thousands of Reddit users started buying the shares. Joining the Reddit users were many people who are not fans of short sellers and would like to see them be less successful.
That quickly drove the price of GME higher, leading to what is called a “short squeeze.” As the price went higher, the cost to replace the shares went up, leading to losses for those who had shorted the stock. Hedge funds wanted to close these bets as fast as possible, but the only way to do that was to buy the stock, leading to more demand and even higher prices.
This chart shows the magnitude of this effect. Over just a few days, the share price rose from below $40 to nearly $480. Keep in mind, there was no fundamental change in the business or its future outlook during this time. It was a 12x price change just based on short-term demand. Generally, the price of stocks reflect their underlying fundamental long-term value, which is why we saw the shares come back down nearly as fast as they rocketed up, leaving many of the later investors with massive losses.
How does what happened with GameStop affect average investors?
A positive effect of the GME saga has been an increased interest in the stock market and more people becoming familiar with investing. My hope is that we can build on that interest and educate these new investors to the virtues of long-term investing, rather than just short-term ‘get rich quick’ schemes.
On the negative side, many people feel this is further evidence that the stock market is akin to gambling and the game is rigged. In this situation, that can be seen as a fair point, given how disconnected the stock’s price became from its fundamental value. This is why Sagace Wealth uses a broadly diversified approach to reduce an individual’s stock risks. We also invest for the long-term, since short-term distortions tend to revert to the mean over time.
What should people new to the stock market do now?
It’s important for investors (even novices like many who bought GameStop stock) to know that buying an individual stock based simply on the premise that others will buy at an even higher price is not investing, it is called trading.
It can be fun, and for some of these traders, quite lucrative. But it should only be done with a small amount of your investment portfolio that you can afford to lose entirely. Your core investment and retirement portfolio should be broadly diversified and invested according to your long-term goals. This is what we do at Sagace Wealth.
If you are new to investing, take the time to educate yourself on risk and have realistic return expectations. There is no free lunch in investing. The only way to achieve stratospheric returns is by taking massive risk. Instead, only take the amount of risk you are comfortable with, and know what you’re getting into before making any investment or trade.
In the case of GME, this was a short-term trading strategy and not a fundamental investment. When executing a trading strategy, you should define your ‘stop loss’ and profit objective before entering the trade. For example, if you bought in at $50, you may want to limit your losses by selling if it drops to $40 and have the discipline to exit if it hit your price target of $100. Again, this is a trading strategy and not long-term investing, so we would always recommend such a strategy only for a small amount you are prepared to lose entirely.
If you were among the many folks who lost money on GameStop stock (or with any other quick trades you’ve made), learn from your mistakes and use a more diversified approach going forward. Start to rebuild your investment portfolio by making regular contributions to a retirement plan or brokerage account.
Also, work with a financial advisor to create a plan and stick with it. Many investors let their emotions dictate investment decisions. A good financial advisor will keep you on a stable and predictable path for long-term success. If you’re ready to talk with a wealth advisor about your investment future, email us at info@sagacewealth.com.