If there is one thing that we should all have learned from the memorable Reddit driven short squeeze on GameStop, it is that everybody has their price.
The hedge funds that were shorting the stock eventually settled a price to buy at that would give them the “least worst” outcome.
And despite the plaintive pleas not to sell on the WallStreetBets Reddit forum, even millennials proved to have their price when they wanted to start cashing in some of the mega trading profits that they had made during the squeeze.
Ignore the votes and check the weight
While it is true that markets can stay irrational longer than you can remain solvent, so is Warren Buffett’s memorable quote from 1973 that “In the short-run, the stock market is a voting machine. Yet, in the long-run, it is a weighing machine.’’
And so it is that after an amazing flurry during which GameStop shares vaulted dramatically to what was almost certainly many hundreds of times their actual intrinsic worth, now they are slowly but surely reverting to their “weight” rather than their “vote”.
That is not to say that markets will just return to normal after this episode given that the volatility and market fragility that it engendered is still very much in evidence.
However, it does mean that once the now crowded exits for GameStop shares finally clear, we will be back to somewhere approaching the rational, long term price for the company’s shares.
There have been a range of very valuable lessons to be learned from this episode which pitched an army of organised little guys against the Wall Street might of hedge funds that thought they had found a sure-fire way to make money short selling another company.
Beware of leverage and don’t underestimate ability
The first lesson is for the hedge funds, that they need to be much more careful in two areas – underestimating the ability of small, young investors to organise and using too much leverage in applying their short selling tactics.
In the case of GameStop, it appears that they actually short sold more shares than were in existence, which is surely a bad idea in anybody’s language, even if it may have been a successful tactic in the past if there is enough stock turnover and little buying pressure.
More to be made backing winners than picking losers
The second lesson is that there is always much more money to be made in backing companies that have a good business than in trying to make money from companies that are arguably over-valued.
Take, for example, a keen WallStreetBets nerd who backed in her hunch and bought some GameStop shares at US$20 on 11 January.
If she managed to pick an exit point of US$347.51 on 27 January, that represents a trading profit of more than 1,637% – an exceptional short term trading profit.
Even if she missed that peak and sold for US$325 on 29 January, that is still more than 1,520% or, in more understandable vernacular, more than 16 times your original investment.
These are whopping and probably totally unrealistic returns even for a good trader on GameStop but they outline the potential profits to be had on the long side of trading or investment.
In the case of the hedge funds, the billions of dollars of losses they wore were accrued chasing a much smaller return, although, arguably, that return would also have been greatly magnified by the leverage they used which instead ended up turning around and biting them hard.
Sure, hedge funds have made plenty of billions shorting stocks, at least some of which probably didn’t deserve the negative attention but they have also been taking on risks to get that money.
This episode showed just how big those risks can be in the unlikely but still possible event of a short squeeze, when the real value of a company’s shares can be lost in the flurry of excitement when one group of people realise they are holding something somebody else needs to buy, no matter the cost.
Now, those same hedge funds will need to take a much more careful approach in shorting company shares.
The organised little investors will be watching them like hawks, newly emboldened by their successful short squeeze and hopefully also greatly enriched by it.
Share market is a wealth generating machine
A third lesson to be learned is that the share market is a great place to build and lose wealth and can offer some exciting rides and terrifying dips along the way.
While the GameStop case is a very unusual and highly volatile one, it encompasses all of the excitement and terror that the market can inflict in one tiny package.
I think it also shows the great advantage of buying a diversified portfolio of shares for the long term and building wealth slowly but that is what you would expect an investor to say rather than a trader.
Even traders must admit though that there is a value in sleeping at night, which is why even the most hairy-chested WallStreetBets trader will probably one day morph into the sort of index ETF buying “loser’’ that they scoff about in their very entertaining posts.
What this episode will hopefully encourage is the next generation of share market players, be they thrill a minute traders or stodgy, long term investors.
Everybody is in it for themselves
The final lesson to be learned may be a tough one for the millennials to hear but it is that in the end, everybody is an individual on the share market.
On the way up you may have plenty of friends and fellow travellers buying up GameStop shares and making bold pronouncements about riding them to Mars with rocket ship emojis.
In the end, there is no amount of hectoring and “don’t sell” pleas that can hold back the flood of sellers as they suddenly realise the seemingly endless bounty of paper profits is starting to erode faster than they can post about it.
While this battle was cast as one between Wall Street and the nerds, in the end it is actually a battle between hundreds of individuals, all making decisions that suit their individual circumstances.
If you are a nerd who wants to sit on GameStop shares forever, that is your right but if your mate wants to sell his to pay off his college loan, that is also fine.
There is no right or wrong answer, only personal accountability for personal decisions.
The great thing about this rule is that it applies with even more force to the hedge funds, which have long preened themselves with the sure knowledge that they are the smartest guys and girls in the room.
Buffett beat the hedge funds but they didn’t learn
Warren Buffett showed them the folly of that boast way back in 2008 when he beat them in a $1 million trading battle over 10 years with a simple fund on the S&P500 index.
Buffett’s contention was simple – that the hedge funds’ exorbitant fees were out of step with their investment performance – and he was proved absolutely right.
The fact that the hedge funds still need to learn the lesson that their fees are too high and their performance is below par shows that the benefits of passive versus active investment strategies are still poorly understood.