Unless you’ve been living out in the wilderness for the last few weeks, there’s a pretty good chance you’ve heard about the recent events with GameStop. The idea of everyday people using social media to band together and soak predatory hedge funds makes for a great story, and it has already driven a crazy amount of previously uninterested investors towards exploring what it would take to ride the same wave.
One such inquiry from a good friend was a bit of of a wakeup call. The same person who never before expressed the slightest interest in investing suddenly wants to know how to buy the next potential short squeeze stock he saw people talking about online. This article is not only for him, but also for the many other people new to investing who are wondering the exact same thing.
This is awesome! How do I join in! 🚀🚀🚀🚀🚀
Contrary to what you might expect from a guy who writes extensively about low-risk index investing, I’m not going to try to talk you out of it. It’s your money, I’m sympathetic to the underlying motivation that goes way beyond making a quick buck, and some investing lessons are best learned through good old-fashioned experience. But there are definitely some massive risks lurking in the shadows just waiting to take down naïve investors who may not fully understand what they’re getting into. So if you’re following the GameStop news and considering getting in on the action, here’s how you can do it responsibly without going full Leeroy Jenkins.
What’s going on
Even for people eagerly keeping up with the news, the actual circumstances can still be quite confusing. Here’s the high-level story as I understand it.
GameStop has been struggling lately due to the double-whammy of increasing online game purchases draining their customer base and COVID-related lockdowns that have crushed all businesses depending on physical foot traffic. As a result, they became a popular target of short sellers who are willing to place financial bets that their stock will continue to fall. The way that works is that someone — let’s call him Melvin — pays a fee in order to borrow someone else’s shares with the promise to give them back at a future date. In the meantime, he sells the shares at the current price believing that he can repurchase them at a lower price before returning them to the original owner. Melvin can make good money if the stock price falls as expected, but if it appreciates in value he can lose big.
Even if it sounds shady to bet on a stock to fall using shares you don’t actually own, many economists argue that short selling is an important mechanism in the price discovery that makes the markets tick. I honestly have no dog in that fight and simply recognize that (no matter how you feel about it) shorting a stock is legal, common, and likely to be around for a long time.
Now in this specific situation, however, Melvin got greedy. Instead of borrowing a small chunk of GameStop’s stock to short, he managed to amass a huge volume of shares that, combined with the shorts by several other big players, apparently added up to more shares than actually exist. If that makes no sense to you, you’re not alone. I don’t pretend to get it either, but the end result was a massively risky situation when it’s time for all of those borrowed shares to be repurchased and returned. What if there are no stocks left to buy at a price Melvin can afford?
Enter WallStreetBets, a popular Reddit forum with millions of subscribers sharing investing ideas. A perceptive individual recognized the situation all the way back in September of last year and suggested that if everyone bought GameStop stock and held tight, it would buoy the price to the point where Melvin would not only lose massive amounts of money but also be forced to buy back his huge number of share obligations at increasingly higher prices. And this influx would create a feedback loop that would launch the share price to the moon. Well, lots of interesting ideas get tossed around in a forum of random small-time investors and most of them don’t work out. But this guy was onto something, enough people got on board to push a perilous situation over the edge, and the eventual chart speaks for itself.
And that’s when the chaos started. Reddit posters made millions on paper, hedge funds with big short positions (notably our story namesake Melvin Capital) lost billions, and all hell broke loose. People around the world started frantically trying to join the fun. Faced with a crush of new money for a single stock that couldn’t be financially covered under current securities law, the plumbing broke and brokerages like Robinhood infamously locked out normal investors from buying new shares. Investors cried foul, noting that it rather conveniently benefitted wealthy hedge funds (including some related to Robinhood itself) over Robinhood’s own customers. Rumors spread of shares being sold without investor permission. Talking heads on TV started a flood of hit pieces on WallStreetBets. And the thin veil of market fairness began to lift from the eyes of disillusioned individual investors, with more and more people believing that the deck appears stacked in favor of a handful of well-connected billionaires.
But through all that adversity, WSB persisted and investors are holding strong. The stock is as volatile as it gets, but at this point there’s no turning back. It’s bigger than Reddit, both financially and philosophically. Major hedge funds are now also piling in with serious money that dwarfs anything a bunch of self-described degenerates can muster. And even if they weren’t, it has become a matter of principle for a lot of people who would be happy to lose it all just to break the system they see as fundamentally rigged.
How to (safely) get involved
If you’re one of the many people wanting to either get in on GameStop or perhaps hunt for the next potential target, more power to you. Just keep in mind that depending on how you go about it this is not without significant personal risk.
To be very clear, I own absolutely no shares of GameStop and have no plans to start with this or any other individual stock. I prefer to stick to my trusted asset allocation that consistently meets my financial needs without worry while watching the drama from a safe distance. I’m also NOT a financial adviser, so you shouldn’t make trading decisions solely on what I say anyway. But if you choose to participate in everything going on, here’s how I would suggest doing it responsibly.
Don’t risk money you can’t afford to lose
The thing a lot of new investors may not realize when they look at the huge upswing in the GameStop stock price is that it will likely fall just as quickly. When the short lemon is squeezed dry and all of the new paper millionaires look to cash out, the resulting mass of people looking to sell aren’t likely to find many eager buyers. After all, this was never about the true value of GameStop as a company but about a risky short position that could be taken advantage of. So the price will drop as people take what they can get. Some will surely walk away very wealthy, but many unlucky investors will end up with a tiny fraction of what they expected.
If you’re thinking that you’ll be able to time everything conservatively and come out on top, realize that a lot of the big money on your side right now is no longer other small investors like you but several other hedge funds that saw what was going on and piled in. No matter how you feel about the fairness of the financial system, your safest bet in terms of planning for the worst case is to assume it is definitely rigged against you. Just because you succeeded in taking down a big hedge fund doesn’t mean the others won’t be able to take your scalp on the way out. So buyer beware.
For some people it’s no longer about making money but about proving a point. If you’re one of those people, I wish you all the best. Just don’t do it with money that would genuinely harm you if it ultimately disappears. Know that the high price won’t last. Assume the system may not work in your favor. And think about what you’ll do if you’re the last one left holding the bag. Then plan your investment accordingly.
Never invest in something you don’t understand
If you took the time to read the original Reddit post on the topic you may have noticed a lot of terms you’re not familiar with. Short interest. Call options. Delta hedging. The poster is clearly educated on the topic, and sometimes the most important lesson is that initial realization that you don’t have a clue what they’re talking about.
It’s not something to be ashamed of at all — knowing our limits is one of the things that keeps us all alive to fight another day. Just like a table saw or lathe that most workshops won’t let anyone near without proper training, all of those things can be useful tools in the right hands but they can also take a limb if you don’t know what you’re doing.
So if you want to get involved in something new in finance, start simple. Take the time to learn how investing works and stick only to things you thoroughly understand. When in doubt, just wait. And if you want one place to start, buy and hold a stock (or fund) while practicing the art of flexing those diamond hands and holding strong. That simple act and the resulting mindset will also serve you well long after you move beyond short-term trades and start thinking towards strategic long-term investing.
Stay away from margin accounts
Have you read the reports that some investors had their shares forcibly sold against their will? It sounds truly troubling and deserves serious investigation, but there’s a good chance nothing will come of it and we learn that it was all perfectly legal. That’s because this type of invasive activity by the brokerage is actually part of the standard terms and conditions in many margin accounts.
A margin account is a special type of brokerage account that offers an extra set of features not available in the standard cash-only version. Most notably it allows you to invest borrowed money, and it’s often a requirement for advanced actions like options trading. In return for granting you those features, the brokerage adds additional rights of their own such as the ability to demand their money at any time and even sometimes sell your stocks without your permission. But here’s the really important thing — even if you take advantage of absolutely none of those additional features, the brokerage may retain all of the extra control.
In the case of Robinhood, they’re quite open about the fact that they sign up ALL new investors to margin accounts by default and that you have to specifically “downgrade” to a traditional cash account. That seems insane to me, as most normal people have absolutely no business messing with a margin account (see point #2). And it’s also the opposite of how most brokerages operate, where cash accounts are the default and you have to apply for margin. But like it or not, the end result is that most of the horror stories are likely 100% legal no matter how much it sucks to hear. People just didn’t understand what they were signing up for.
So if you’re opening a new brokerage account for the first time, stick to a cash account. That will help you in three important ways. First, (and while you always need to read the terms and conditions in case I’m wrong) it will most likely help you retain more control over your trading decisions. Second, it should help filter out complicated features like options trading that casual investors have no business messing with. And third, operating on a cash-only basis will help you stay away from the dangers of investing on margin using money that you actually don’t have. Don’t be a Melvin! All investing has some amount of risk, but investing with borrowed money is the fastest way to lose everything.
Diversify to justify risks
While I’ve talked a lot about risk, the good news is that the possibility of losing money doesn’t have to stop you from buying something you find truly compelling. After all, wise investing is not an all or nothing affair. You win some and you lose some, and the people who keep it up the longest are generally just really good about smart risk management. In this case it’s about investing conservatively with a portion of your money so that you can afford to safely take calculated risks without fear.
Guys like Larry Swedroe talk about this in terms of balancing large amounts of safe assets with small amounts of risky assets, while others like Harry Browne spoke in terms of putting most of your money in a Permanent Portfolio that you can trust to fund your everyday needs while saving a portion for a Variable Portfolio where you can speculate on wild ideas to your heart’s content. But the basic idea is the same and is really just about being smart about how much risk you’re willing and able to take on any one bet.
While I’m personally not a day trader and don’t have a lot to offer in terms of hot stock tips, my own area of expertise is in how to construct that dependable part of your portfolio to support the trades you believe in. So while you scour the internet for your next big score, reserve some time to also research portfolios for one that can backstop your best ideas. Even the most talented trader can use a diversified portfolio to always have their back.
To the moon! And with a safe voyage.
I hope nobody gets the impression that I’m trying to disparage the WallStreetBets crowd for their laser-focused enthusiasm or to claim that I know a better way to make lots of money. To the contrary — while I certainly have my own distinct approach, I have a lot of admiration for smart and motivated everyday investors that work together towards a common goal. So in that same spirit, my hope is simply that I can contribute my two-cents to help people safely pursue their goals in a manner that empowers them to keep trying long after the GameStop mania is nothing but a distant memory.
- Don’t risk money you can’t afford to lose.
- Never invest in something you don’t understand.
- Stay away from margin accounts.
- And diversify to justify risks.
It’s not rocket science. It’s just wise investing principles passed down through the ages and I’m nothing but the most recent messenger. In fact, some people may recognize the distinctive influence of the same Harry Browne I mentioned earlier. If you’d like to take a break from the GameStop news to read the work of a successful trader turned defensive investing savant and libertarian candidate for president, I highly recommend his book Fail Safe Investing for these and many more practical lessons that all investors can use.
So get out there and invest your convictions! Just realize that going up against the financial establishment by buying up the stock of a game retailer may sound exciting but it’s definitely not a game. Be smart, stay safe, and think strategically. And keep Portfolio Charts in mind if you ever need a trustworthy portfolio both now to balance risks and in the future to manage your hard-fought gains without so much work and adrenaline.
There’s more than one way to grow and protect wealth, and no matter what you choose I’ve got your back.
Did you turn a great profit and want to support a good financial cause?