By now, you’ve probably heard what’s happening in the stock market with GameStop. It is some once-in-a-generation event or it could be a frequent one going forward if the enabling variables align. The idea is that once a new approach is tasted, it becomes a permanent feature of how things could be handled in the market again.
GameStop is not a company we would have added to our Rise stock portfolio. The hedge fund managers that short it were right, it was a dying company. However, things went the way it did because of a loophole that in hindsight looks obvious.
Shorting a stock means borrowing a stock today and selling it with the expectation that the stock price will go down more in the coming months. When the price declines more, the investor would typically then buy the stock at a cheaper price and return to the borrowed stock. It’s an old strategy.
The way shorting a stock works is that the investor/trader benefits when the price declines and loss when the price rises.
But what happens if what the investor thinks would decline in price starts to increase? They lose of course but that’s not the end. They also need to take action to cut their losses. The action they typically take to cut their loses is called a short squeeze.
A short squeeze occurs when a stock or other asset increases in price, forcing traders/investors who had bet that its price would fall, to buy it to forestall even greater losses. They buy it to cut their losses. Remember they had earlier borrowed the stock with the hope of buying at a lower price. When the price goes higher, however, they need to buy before it gets even higher to cover their losses.
What typically happens in this process is that their attempt to buy the stock only adds to the upward pressure of the stock’s price. And they become trapped oftentimes with great losses. In the case of GameStop, it has been reported that the investors lost about $5billion dollars.
Market irrationality
Again, a short squeeze is triggered when the demand for the stock or other assets suddenly exceeds the supply because of a new level of optimism on the asset driving the price up.
In the case of GameStop, some Redditt users (Redditors) decided to artificially inflate the price because of a loophole they saw. So their optimism was an opportunity to make money by beating the system. As of December 31st, 2020, GameStop had a short interest of about 140% (the loophole). Meaning all that investors could see about the stock are doom, gloom and continuous decline.
Knowing about the phenomenon of a short squeeze, the community of Redditors decided to start buying the stock. This is so that price can go up since their demand is expected to exceed the supply. And so it happened as planned. As at the time of this writing, GameStop is up 1,900% YTD. For context, it means if you had invested $1,000 on January 4 when the market opened this year, your investment would be worth $19,000 now.
Even for the best-run company, no market hypothesis would have predicted that kind of return in such a short time, not to talk of a supposedly dying company. But yes, there is irrationality in the market and anything is possible.
Why didn’t we just invest all your money in GameStop to give you 1,900% already?
Simple, do you want us to get it right once in a lifetime (with a GameStop) or 90% of the time in a lifetime (with a balanced compounding portfolio)? You get it now right? It’s a matter of the odds of success and the safety of your capital. Those are our priorities, what we promised you and why you trust us with your money.
What happened with GameStop is one of the irrationalities that may exist in the market occasionally. Basing your investment principle on such events would most likely be catastrophic. And since we know that buying individual stocks in the market is still an option for a lot of people, we will say this point is also relevant for them and not just to us. Building an investment principle that will give you success 90% of the time is far more sustainable than one that will give you success 1% of the time.
What we want for you is wealth. Wealth that combines the power of your hard work and the compounding effect of the portfolio we build for you to materialize. With such an approach, you would have an enduring wealth built over time, the kind that does not take away good sleep from your eyes.
