Last week, news of main street investors getting one up on Wall Street covered the news. Where will this story of GameStop lead, and does it change conventional investment strategy?
The GameStop Story (So Far)
The price of GameStop shares have skyrocketed by about 1,700% since December, when a group of investors following the WallStreetBets Reddit forum pushed the retailer’s stock to incredible highs. Their aim was to sabotage hedge fund managers’ strategy of shorting GameStop. The fund managers based their moves on a belief that GameStop was in decline, and it’s stock price would decline as well.
What is shorting a stock? Basically, the hedge funds borrowed shares of GameStop and immediately sold them at the then-market price. Since they borrowed the stocks, they had to eventually buy actual shares and return them by a prearranged expiration date. Expecting Gamestop’s price to decline over that time, the fund managers planned to buy and return these stocks at a lower price. The difference between the purchase price and previous selling price is the profit.
Shorting stocks is a risky bet; if a stock price goes up, you have to purchase the stock at a higher price than when you sold it.
Theoretically, a stock’s price could go up infinitely, as could your loss.
The fund managers didn’t expect investors following WallStreetBets to buy up shares of Gamestop and push its price up. But that’s exactly what happened. The individual investors forced the professionals to purchase shares at higher prices to cover their short position. The Reddit group employed a similar strategy for AMC and Blackberry stocks, each of which have increased significantly.
What are the implications?
There are larger implications.
First, the hedge funds, needing cash to purchase these stocks at unexpectedly high prices, might have to raise cash to cover these shorts by selling other investments, creating a potential domino effect with the price of other stocks and the market in general. The markets declined at the end of last week.
Also, since the stock prices of GameStop, AMC, and Blackberry increased for artificial reasons, not because of healthy company fundamentals, investors will eventually stop buying their shares. At that point, whoever holds the shares stands to lose money.
Does this affect conventional investing strategy?
For the average investor, focused on long-term returns and reduced risk, conventional wisdom still holds:
- Invest for the long term — position your investment portfolio for steady, long-term growth. Hold any funds you’ll need in the next three to five years in a cash account like a savings account or a money market fund.
- Diversify your portfolio — establish an asset allocation strategy including large- and small-cap US stocks, international and emerging market stocks, and bonds. As the allocation drifts out of alignment, rebalance your holdings. Consult an investment advisor to determine your ideal allocation.
- Invest regularly over time — contribute regular amounts to investment accounts on a monthly, annual or other regular interval. This cushions your investments from periodic market swings.
With a long-term focus, short-term market disruptions shouldn’t meaningfully affect your outcome. Consult with an investment advisor to determine if your asset allocation and investment holdings are appropriate for your risk tolerance and goals. A financial planner like Copper Seed can review your overall financial picture to determine if you are on track to achieve your various goals.