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What Does the GameStop Debacle Mean For My Investment Strategy?

“A bunch of kids on social media blew up some big Wall Street types with GameStop stock.” We’re talking about this David and Goliath story and what it means for evidence-based investors. Hint: not much!

Transcript

Tim Maurer:
Hello, Tim Maurer, back with another episode of Ask Buckingham, a video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Jared Kizer, chief investment officer of Buckingham Wealth Partners. And Jared, the strangest thing happened last week.

My two teenage sons burst into my home office after school to tell me, and I quote, “A bunch of kids on social media blew up some big Wall Street types with GameStop stock.” Were they right, Jared?

Jared Kizer:
I think that’s a good synopsis, and certainly it was all over the news this past week and just continues. So that, I think, is a fair synopsis certainly at a high level. I know we’re going to get into some of the details and broader context, but certainly you had kind of the retail investment community at some level pitted against a portion of the institutional investor community that we’ll get into. So yeah, fair definitely at a high level.

Tim Maurer:
Okay. Well, then why don’t you tell us maybe something closer to exactly what happened, and in that, also offer a distinction between the retail investor and the institutional investor, as you just mentioned.

Jared Kizer:
Yeah, absolutely. We’ll get into a little bit of nuance here, but it’s important for the question that you’re asking and what the context here is. We know it’s possible for institutional investors to do what is known as shorting a stock, which you may ask, “Well, what in the world does that mean?” But it’s important because it was a big part of this story and an ongoing portion of the story. You think of investing regularly, investing in individual stocks or through stock funds.

You’re investing with the hopes that over time that company or set of companies will do well and the stock prices go up over time. And that’s a synopsis of the really long history of investing in stock markets. The flip side of the equation is there is a way to profit if the price of an individual company goes down, and you do that by what is known as shorting the stock. So, let’s say you’ve got a stock trading at $50 per share. There is a way for you to make money if that stock price declines.

As we saw this past week, it’s a very, very difficult way to make money, because again, over time most stocks go up, but it’s a crucial part of this story. And on your question of kind of what are the roots or the apparent roots of the GameStop situation and some of the other individual stocks that have been impacted, it does appear that a significant portion of the online community was able to figure out that there were a number of institutional investors that were doing a substantial amount of shorting of these individual stocks and try to use the information against those investors that ended up causing those institutional investors substantial losses.

Because when you short a stock, when you do poorly is when the stock price goes up a lot in a hurry. And that’s certainly what happened with the GameStop stock, and again, a number of other companies.

Tim Maurer:
All right. Hold on a second now, Jared. Let’s go back to my investing 101 course in college, right? The objective, if I’m hearing you correctly, is typically to buy low and hopefully to sell high, right? Well, the notion of shorting then is actually selling high with a hope of a stock going down in value. How exactly does that work? How do I sell a stock that I don’t have?

Jared Kizer:
So again, you get into some technicalities here, because it is something that when you first hear it, a lot of folks understandably would say, “This does not make sense to me.” And you’re asking, how is this even possible to do? Well, what you can do is what is known as borrowing stock from somebody that owns the stock. So, say you’ve got a long-term investor, like a mutual fund that owns GameStop in their portfolio. They can lend that stock out to people, and then people are then able to short that stock.

So, since you’re selling something you don’t own, as you know, you’ve got to find it somewhere and you do that through a somewhat opaque portion of the market called the securities lending market. And that’s the whole mechanism for allowing people to short that stock. And then let’s say they ended up getting that right. They short the stock and the stock goes down. They end up having to basically buy that stock back to close out that particular transaction again. They’re hoping it has gone down and hoping they’re closing the transaction out at a profit.

Again, that’s the exact opposite of what happened to those investors in this particular case.

Tim Maurer:
Yeah. So, in this case, when we’re talking about shorting, I assume there’s going to be a cost to this lending or borrowing of the stock. But in addition to that, I remember this fundamental principle that when you buy a stock, let’s say you buy it at $50 a share, the very worst you could do is lose 100% of that investment, right? So if you bought $50 worth of stock, you could lose your 50 bucks. But in this case, these investors, these institutional investors, were shorting GameStop at around 50 bucks.

And then it went up to like $300. So, did they actually lose more than they “invested” there?

Jared Kizer:
Yeah, that’s exactly what happened. Each investor will have a point to where the losses are so severe that they have to get out of their short position. And that, again, is exactly what happened in likely a number of cases. Because you’re 100% right. When you’re investing in stocks, normally the worst, which is still bad, but the worst that can happen is losing all of what you invest. Here, you can lose multiples of what you invested and therefore have to come up with those additional sums of money.

And for most investors, including institutional investors, if it goes up enough, you have to completely remove yourself from the trade. And again, that’s the kernel of the insight of the individual investors realized that dynamic. Hey, if we can make this go up enough, some of these investors are going to have to essentially close out their positions. And again, that certainly happened to a number of institutional investors that face steep, steep losses.

And it’s one of those reasons why generally we would say certainly for most investors, shorting is just not a good idea. This is an extreme example of what can happen when you’re shorting. But in general, one of the most important things to understand is that it is possible for you to lose more than you “originally invested” in the position as time has demonstrated and we’ve had demonstrated many, many times over in other cases that aren’t nearly as well-known as the GameStop example that we’re going through.

Tim Maurer:
So, in this case, we had the retail investor, the regular Joe investors, pitted against the institutional investors who in this case had been the ones to short GameStop pretty heavily. But is this true that the retail investors, the regular Joe investors out there, actually kind of colluded or got together via social media in order to decide to do this and drive the price up?

Jared Kizer:
That, again, does appear to be the case. I saw somebody online, I wish I could remember who, that referred to this as a “crowd squeeze,” which is I think a new term. And they had to be ecstatic that they came up with something that creative. Because as far as I know, at least in terms of things that have gotten attention where it was clear that this has happened, this is the first example I’m aware of, of where you had a dynamic where it literally was a crowd motivated kind of movement that led to what we’re talking about here.

Typically, if you went through the history of markets and said, “What are the things that are most similar to this,” it would typically be like institutional investors crowding out other institutional investors, not like collusion essentially at a large, large herd of individual investors kind of acting in the same direction. As far as I know, at least of anything approaching this magnitude, this is the first example that I’m aware of, which does make it something close to unique from that perspective.

Tim Maurer:
The crowd squeeze, of course, is alluding to the notion of a short squeeze where you have people who then are forced to go and get out of their short position. Of course, what this does is you have to buy the stock at that point in time, so it creates more pressure on the upside, right? I mean, this concept of a short squeeze, this might be the first time it’s happened where the retail investors were kind of pitted against the institutional investors. But is this common? Has this happened before? Is this unprecedented?

Jared Kizer:
The short squeeze concept has absolutely happened over and over again. It’s one of the biggest risks that institutional investors know they face when they short a stock, is there is some potential, in this case, I’m sure they never anticipated that risk would come in the way that it came, but there’s certainly the potential for you to get squeezed out of your position, which again, all that means is the price of what you’ve shortened has gone up so much, you can’t stay in the position anymore.

You’ve lost multiples of the original wealth that you had dedicated to the transaction. So that has absolutely happened many, many times in the past. Certainly it happened in the late ’90s. You can imagine late ’90s, for anybody that was investing during that period, as we had a huge boom in the tech sector.

There were a lot of folks that said, “There’s no way this company is worth what their stock is trading at, so I’m going to short the stock,” again, this term that we keep using, “because I know that it’s going to go down,” only to see those stocks continue to go up. They may have been right eventually, but they got squeezed out of the position. And in our world in financial services, that’s called a short squeeze. Basically, you’re getting forced out of your position. And that part is not new.

Again, that has happened many, many times in the past. That will happen at some point here in the future again as everything moves forward.

Tim Maurer:
Yeah. It reminds me of the Mark Twain quote, “History doesn’t repeat itself, but it often rhymes.” This is a different version of what we’ve seen, but it’s a story that goes back a long way. It is a common happening. If not, the most common way to see it. Now, GameStop was the headline stock in this particular case, but it seems as though it has spread to others. Have we seen that as well, that other securities have had this phenomenon take place in recent days?

Jared Kizer:
We have. There’s a growing list of names at this point, some of which I’m sure many of our viewers have already heard. Bed Bath and Beyond. AMC has been put in the mix here as well. So it certainly does appear to be that there have been more than one name impacted, although GameStop is the one that kind of drove the whole story. But what I’d emphasize there may seem a little bit frightening at some level, because I know some people thought, well, if it can happen to a handful of different stocks, what’s preventing this from just happening here, there, and everywhere?

I think at this point, it’s important to keep in mind, and I know we’ll come back to some of this a little bit later, but one thing to keep in mind is that almost all of these stocks were relatively small companies as far as publicly traded companies go. These are companies that were trading at relatively low prices. Some seem to be on the verge of real, real trouble from a corporate perspective.

And I think that’s part of what made this possible, meaning that these companies were not large enough to not be impacted by a lot of people moving in the same direction at the same time, even though we’re talking about individual investors here. I think that’s a big part to keep in mind here that all of these names were relatively small companies as far as publicly traded companies go. And that’s almost certainly one of the reasons why what we’ve seen was able to happen in the first place and have the moves in those prices, the magnitude that we’ve seen.

Tim Maurer:
Does this sort of crowdsourcing or social media driven frenzy, is it any bit similar to what we’ve seen happen with Bitcoin recently? Because there we also saw a huge run-up and then a pretty big fall from that price. Is it a similar concept that’s at play here?

Jared Kizer:
I think it’s somewhat similar, but with some interesting distinctions as well. One would be this concept that we’ve talked about with shorting doesn’t really exist in a super fluid way for something like Bitcoin. You don’t have this dynamic that ended up being a big, big dynamic here of essentially, again, the institutional investors getting squeezed out of their positions and then just amplifying the whole phenomenon. You don’t really have that here. But I think one thing that is similar is that it’s really hard to know precisely what any individual company is worth.

That’s a huge part of our philosophy, one of the reasons why you want to diversify across a lot of different companies. This isn’t physics. Nobody knows exactly what GameStop should be worth or Bed Bath and Beyond, even though we know at this point they’re well, well beyond whatever that number is likely. We don’t know. I think the same thing is true for Bitcoin. There’s a lot of uncertainty. Is this a legitimate thing? How legitimate will it be over time? Will it be replaced by something else?

So anytime there’s that level of uncertainty about anything in investing, you’ve got the potential for either big, big run-ups in the price of that thing, or big, big declines in the price of that thing. So I think there is similarity there, is that these things can happen where you do see these big, big moves in a particular thing, because there’s so much uncertainty or just got a lot of complexity going on and how markets function. So from that perspective, yeah, I think there are some similarities.

Tim Maurer:
Appropriately or not, Jared, the analogy is often used for the market to liken it to a casino. And when you see these types of things happen, it almost makes it feel like it is a casino and it’s great. It could cause investors to start to lose confidence in the overall structure of the market and portfolio investing. Is that appropriate? Should we be scared right now?

Jared Kizer:
I definitely understand where that question comes from, and I’ve gotten that question already. It’s completely understandable, because when you see episodes like this where a lot of times one of the interesting parts about investing in one thing that can get people into trouble is you will hear people make a claim, “Well, this thing is overvalued. That thing is undervalued.” The reality, 99% of the time, nobody really knows. They’re just speculating there, and you probably shouldn’t follow that advice one way or the other.

This is a clear example where I think everybody in our world and even individual investors out there say it’s almost 100% certain the prices of these companies have just been disconnected from fundamental reality at this point. And that is disconcerting at some level, like how can a market be this out of whack for a period of time? Now, first thing I’d go back to is, again, these were relatively smaller companies.

Second thing is, even though we know markets go up over time and there are periods like this, again, not the exact set of facts that we’ve got here in terms of how this came about, I mentioned that part, is distinct, I think. But the idea that that markets can be irrational at some level, at least in hindsight, that does happen periodically. It doesn’t happen frequently. If it happened really, really frequently, we would see lots of evidence of people able to easily outperform markets over time and lots of other things that we just don’t see.

Markets are by and large competitive. That’s not to say they’re perfect at all points in time. And it’s also to say, even if they go through periods like this, it’s very, very difficult still to try to profit from that in terms of saying, “Hey, I see this going on and now I’m going to try to profit from it.” I’m sure that’s exactly what a lot of these institutional investors told themselves before this happened. And now they, in some cases, are shuttering their doors.

Just because you see periods like this, doesn’t make it easy to profit from it in any meaningful, sustainable way. Again, in hindsight, we’re going to see that certainly there are some investors that made a lot of money here, but doing that systematically over time, and a lot of people being able to do that. We just don’t see it. And again, the thing that I would always come back to is you can see things like this in the shorter term. But in the longer term, what we know is that markets are weighing the health and profitability of companies.

It doesn’t mean that’s happening every single day in every single instance, but for long-term investors in stock markets, that’s what it ultimately becomes about. And the short-term movements just aren’t as meaningful from that long-term perspective.

Tim Maurer:
You can correct me if I’m wrong here, but I think it’s Warren Buffett quoting Benjamin Graham, the father of value investing, referring to the market in the short-term as like a popularity contest or a voting machine. But over the long-term, it rationalizes out almost. It becomes more of a weighing machine, I think the quote goes. Is that right?

Jared Kizer:
That’s basically the quote and that’s one of the best analogies that we hear. I think that’s exactly the right way to think about the stock markets, because there is that big distinction between what’s possible and how to interpret what’s going on in the short-term basis versus what the longer-term histories of financial markets show us.

Tim Maurer:
Yeah. All right. Now, you and I ascribe to an evidence-based approach to investing, which calls us to diversify comprehensively across a number of asset classes in our portfolio. What does it mean for me if I am a disciplined long-term investor? Do I need to worry about this stuff?

Jared Kizer:
I’d say thankfully at this point it doesn’t mean a lot. If you’re an evidence-based investor and you’re investing in the stock market, you’re going to own hundreds and thousands of companies effectively through the stock funds that you own. You just don’t see things like this having a material impact on those diversified portfolio. That’s, again, one of the beauties of diversification is that it mitigates these types of risks and exposures that a long-term investor would have.

So I’d say even though it’s certainly been very interesting to watch, and I’d be the first to say, we don’t know exactly where things will go from here, I never want to be in the business of predicting short-term what’s possible or not in the stock market. But again, from a diversified perspective, when you have thousands of holdings in your portfolio, again, what you’re really, really worried about or you’re thinking about from an investment point of view is what we just talked about, which is on average stock markets go up over time.

And what it’s way, way more about is the health of the global economy long-term and how corporations are doing from a sales and profits perspective. And that’s, of course, not what this episode is about. And that kind of all tends to wash out over time for a diversified portfolio.

Tim Maurer:
It’s one of my favorite things about being a diversified long-term investor is that these short-term eccentricities really just become academics. I mean, verging on entertainment. It doesn’t feel like it if you’re the one in the short squeeze here. But if you just stay in that business completely, you don’t need to worry about it.

Jared Kizer:
Right. Absolutely right.

Tim Maurer:
Well, Jared, thank you so much, and thank you for tuning into this episode of Ask Buckingham. If you have a question you’d like us to address, you can do so by navigating to the website askbuckingham.com, or by emailing your question to question@askbuckingham.com, or just click in the upper right-hand corner of the screen right now and it’ll take you directly to the website. Remember that there are no dumb questions. But unfortunately, there are plenty of poor and misleading answers out there.

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