Who gets left holding the bag? An investing lesson from GameStop

I’ve been following the GameStop (GME) story over the past week. I don’t think that I have even seen anything like it in all of the years that I have been watching markets.

The story has taken on a life of its own and as usual, when so many people are paying attention, there has been a fair amount misinformation and misunderstandings.

In case you haven’t been following it, here is some background.

Background

GameStop (GME) is a speciality retailer of video games in the USA. They sell their games through brick and mortar stores, not online. The business is loss-making, although they hope to turn a profit in 2023. In reality, the business has been slowly dying for years now.

A number of hedge funds had been “short selling” shares in the company for some time. Short selling = borrowing shares, selling them, then waiting for the price to GO DOWN, before buying them back at the lower price and giving them back to the people you borrowed them from. You make a profit if the price that you buy the shares back at is lower than the price you sold them at.

As of December 2020, more than 100% of the outstanding shares in GameStop were being sold short. I.e. investors were overwhelmingly betting that this company was toast.

However, often, having so many investors on the same side of the boat can lead to unexpected outcomes.

In this case, some tech-savvy investors on a Reddit forum called Wallstreetbets decided there was some value in GameStop shares after all, or at the very least, they thought that there was a way to profit from the sheer amount of people betting against the stock.

They pushed the price of the shares up (by some 1,600% in January) which squeezed the short sellers and forced them to buy back the shares that they had borrowed to sell short, in order to cover their losses.

In the process, they took down at least one highly respected hedge fund, Melvin Capital.

Who gets left holding the bag

The original members of the Wallstreetbets Reddit group got in early. Their strategy was brilliant and they made a lot of money. Many of them have already moved on to new targets (e.g. Blackberry, AMC, silver)

Hedge funds, despite some of them wiping out early, also made a pile of money on the back of the ensuing volatility.

However, now there are people jumping on to the bandwagon who just see something going up in price and have no idea why this was an investment opportunity in the first place.

Like the loser in a game of pass the parcel, they will be the ones left holding a stock that is way overvalued and will get their fingers badly burned when the GameStop share price inevitably meets with gravity.

Investing is not entertainment

As entertaining as this story has been, it is not really about investing.

Investing is and should be boring. You hold a well diversified portfolio and then wait for compounding to work its magic. That is Warren Buffet’s real secret sauce.

What is happening with GameStop goes in the same basket as putting money into crypto currencies or having a night at the casino. It is gambling or speculating.

That doesn’t mean that it is wrong.

There is nothing wrong with going to the casino with some “fun money” – i.e. a set amount of money that, if it were lost completely, would not make a meaningful difference.

The same goes for having a separate trading account, with an amount that lets you “scratch the stock-picking itch” but that if it all goes pear-shaped won’t derail your core financial plan.

However, these are things to be done once the financial basics (emergency fund, retirement contributions, life insurance, etc.) have been covered. Not as a “hail Mary” substitute for them.


Thanks for reading!

If you enjoyed this post or if you learned something new, subscribe below to get my future posts sent directly to your inbox.

* I won’t send you spam, I promise (I hate it too). You can unsubscribe at any time.

By Ross Naylor

Ross has been a financial adviser for the past 26 years. He uses the experience that he has gained over this time to help busy expats to understand their options, make smart decisions and avoid costly mistakes.