By Barbara O’Neill, Ph.D., CFP®, [email protected].
Recent news about the meteoric rise of GameStop stock caused by an organized group of online traders provides a “teachable moment” for Personal Financial Managers (PFMs) and other financial educators. Many people have questions about exactly what happened and are interested in learning about the risks and rewards of stock investing.
I recently attended a Next Gen Personal Finance (NGPF) webinar about the GameStop/Reddit/Robinhood story and its implications for financial education. My biggest take-away was that there are six key “moving parts” to this story and the best way to fully understand it (and to be able to explain it to others) is to break it down.
Below is a brief description of each piece of the story for PFMs to share with service members:
Troubled Companies
GameStop (GME) garnered the most attention. A video game and electronics retailer, it was already in decline before COVID-19 due to a rise in digital gaming and a shift away from packaged game products. The pandemic added supply chain disruptions and decreased traffic in its remaining stores.
Other troubled companies included AMC Entertainment Holdings (AMC) and Blackberry, Ltd (BBB). About a week after the stock-trading frenzy subsided, organized online traders turned their attention to mass purchasing in the silver futures market.
The Process of Shorting Stock
To “short” a stock, people borrow stock shares from a broker and sell them immediately at their current price. Then they bet against a company by hoping that its share price will fall so they can buy the stock back at a lower price, return the borrowed shares to the broker, and pocket the difference in share prices as a profit.
Of course, shorting can also backfire. If share prices rise, instead of dropping, investors must buy the stock back at a higher price to return the borrowed shares and the difference in share prices is a loss. Since share prices can theoretically rise indefinitely, potential losses can be unlimited, resulting in what is known as a “short squeeze.”
Hedge Funds
These are financial partnerships that use pooled funds from investors and high-risk investing strategies, such as shorting the stock, in an effort to realize large capital gains. As their name implies, they try to make money in both up and down markets. Hedge funds that heavily shorted GME and AMC lost billions of dollars when an organized group of individual traders (see below) pushed up the share prices of these stocks. There were about 10,000 active hedge funds in 2019.
A social news aggregation website, Reddit, is a place where registered members submit posts, links, and images. Votes are taken among members with the goal of featuring well-regarded content on the site’s first page. Reddit is composed of “subreddit” groups including r/wallstreetbets (r/WSB) with content moderators (mods).
Members of r/WSB learned that several hedge funds had large short positions in GME and spread the word “Buy, do not sell.” r/WSB members have a unique culture, words, and mindset including “stonks,” when discussing stock losses, and FOMO (Fear of Missing Out) when someone risks their entire portfolio on a single stock or options trade.
The Robinhood Platform
An online stock trading platform founded in 2013, Robinhood allows investors to trade stocks, stock options, and exchange-traded funds (ETFs) without paying a fee. It makes money on spreads between buy and sell prices per share and interest on margin loans (loans to investors to buy stock). Robinhood has game-like features (e.g. emojis and falling confetti) that are seductive to inexperienced investors, who are often drawn to risky trading strategies. In June 2020, a 20-year old student committed suicide when he mistakenly thought his account statement showed a three-quarters of a million-dollar loss.
Robinhood’s approximately 20 million users trade stock options (i.e., puts and calls to buy or sell stock at specified prices or dates) 20 times more than other retail investors. Robinhood enabled mass purchases of GME and other distressed stocks until its clearinghouse demanded it posts billions of dollars as a cushion for operational expenses.
To address risks to the clearinghouse and lower its cash demands, Robinhood prohibited customers from buying GME and other restricted stocks, even when not purchasing on margin or with options. This drove share prices down quickly and made Robinhood users furious and floating theories that the company was trying to shield hedge funds from losses.
Trading Triggers
Explanations for what spurred this online trading frenzy include greed, FOMO, pandemic boredom and stimulus money, a herd mentality in the r/WSB group, overconfidence, social pressure, the lure of quick money, a lack of financial education, and a desire to “stick it to the man” (e.g., wealthy hedge fund traders, “elites,” and Wall Street itself).
Take-Aways
A key takeaway for financial educators is to use current interest in stock investing as a “teachable moment.” Key insights to share include:
- Pure speculation is not investing
- Most people do not get rich overnight
- Margin loans and shorting stocks are high-risk practices
- Market timing is difficult to do on a sustainable basis
- Cognitive biases, such as overconfidence, can cloud investment decisions
- Day traders face an income tax nightmare calculating short-term capital gains on multiple trades
- There is no such thing as a “perfect” slam-dunk investment (i.e., risk-free, tax-free, with a high return).
- We can’t afford to lose a generation of stock investors due to their Robinhood losses in early adulthood. Successful stock investing requires patience and a long-term perspective.
For additional information about the GameStop/Reddit/Robinhood stock-buying frenzy, review this CNBC piece on GameStop lessons by NGPF founder Tim Ranzetta.
Photo by Andrew Neel from Pexels
