After more than 40 years in the financial services industry, I have come to recognize the impact that human behavior has on investing. In the past this behavior was confined to individual choices but advances in technology allow groups of investors to discuss and coordinate strategies directed towards individual securities.
The most glaring example of this mindset is the wild daily gyrations in the share price of companies on life support resulting from obsolescence, poor management or both. These so-called “zombie” companies such as GameStop, AMC and BlackBerry have experienced seismic moves in their share price as speculators trade massive amounts of shares on a daily basis.
The escalation of activity in trading these stocks is a confluence of many factors – idle time by small retailer investors, zero trading costs on platforms such as Robinhood, additional liquidity provided by stimulus checks and federal unemployment payments as well as websites such as Reddit that sponsor sub-reddits such as WallStreetBets which provides a forum for small investors to exchange ideas and collaborate on investment strategies.
To appreciate this phenomena, it is important to understand the mechanics and purpose of short selling. When an investor believes the share price of a company is overvalued, profits can be earned by short selling. This strategy involves borrowing shares of the company from another investor, selling them immediately and, if their assessment is correct and the share price declines, buying the shares back at a lower price and repaying the investor. The difference in share price between selling borrowed shares and buying them back at a reduced price represents profit. However, if instead share prices rise, these short sellers may need to scramble and repurchase the shares at a higher price in order to avoid incurring catastrophic losses.
Since many institutional investors such as hedge funds disclose their short positions, retail investors led by activists such as Dave Portnoy of Barstool, promote buying or “going long” on these shorted stocks in order to inflate the share price and force institutional investors to “cover” their shorts by purchasing shares which further raises the price. These moves and counter moves by all parties represent the primary reason for this extreme volatility. Furthermore, these advocates have promoted options strategies which makes bets on the movement of share prices without actually owning the underlying stock. In effect, options trading is like speculative stock trading on steroids and can result in enormous losses. Only seasoned options traders who can accurately assess the potential financial damage should participate in these strategies.
An acronym that has been used often in the recent past to describe human behavior, FOMO, Fear Of Missing Out, has been one of the main factors resulting in the wide swings in the price of GameStop. There are many documented stories led by the apparent instigator of this strategy, Keith Gill, who has reportedly made up to $40 million on trading GameStop stock. This type of activity is not investing but gambling and is prudent as long as you know what game you are playing and the potential loss you may incur. Just recently, a 20 year old student committed suicide because he was informed by Robinhood that he owed $730,000 due to options trades gone bad. He was told that he needed to pay $170,000 within days to make the account solvent. His initial investment was a tiny fraction of the reported loss and he was completely blindsided by the mis-stated loss and took his own life.
Let’s take a step back and place these events in perspective. Companies such as GameStop subject to these trading patterns, tend to be nearly bankrupt, not on the cusp of a financial or business revival. Think of the logic behind these moves – companies on the brink of going out of business experience astronomical increases in share prices often exceeding thousands of percent in short periods of time. If the inevitable occurs and the companies become insolvent, shares would become worthless. For unlucky investors who hold onto these vastly inflated shares instead of selling them at a profit, the end result will be devastating.
Of course, the price could continue to rise before the bottom falls out. It is a little bit like musical chairs where the last person standing is the big loser. If Dave Portnoy with a reported net worth of $120 million loses $700,000 in one trading day as he announced, he can easily absorb the hit. But the small retail investor who ends up holding the short end of the stick and doesn’t fully comprehend their financial exposure will ultimately be the big loser.
Clifford L. Caplan, CFP®, AIF® Stephen Caplan, CSLP®
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Announcement: Cliff is honored to be named a 2021 Five Star Wealth Manager in the Boston area for the 10th consecutive year.
2021 Five Star Wealth Manager Award, created by Five Star Professional. Presented in 2/2021 based on data gathered within 12 months preceding the issue date. 4069 Boston area advisors were considered, 480 advisors were recognized. Advisors pay a fee to hold out marketing materials. Not indicative of advisor’s future performance. Your experience may vary. For more information, please visit www.fivestarprofessional.com.