The GameStop/Reddit clash could have been taken straight out of a Hollywood film: it had our hero, the so-called “little guy”—individual investors, in this case—taking on powerful Wall Street hedge funds that had unknowingly left themselves vulnerable.
But what does this drama mean to long-term investors? Will it be a footnote years from now, or does it have wider implications? Let’s first break down what happened.
How we got here
The events of late January and early February were the crescendo of the biggest “short squeeze” the US stock market has seen in years, according to Goldman Sachs.
The move really grabbed attention on January 13, when shares in mall-based video-game seller GameStop, the company at the centre of the storm, jumped from $20.03 at the open to $31.50 at the close, a 57% surge in a single day.
At its peak, on January 27, GameStop closed at $347.51, up 1,635% from its January 13 opening price. Shares of other targeted companies, which came to be known as “meme stocks,” also saw big swings.
The details behind these moves are both typical and extraordinary: before the drama unfolded, some major Wall Street hedge funds were holding large “short positions” in GameStop and other struggling firms.
A short sale is a bet that a company’s share price will fall. Under this technique, you borrow a stock you don’t own from your broker, who sells it right away and holds the proceeds in your account. If the stock declines, you’d then buy your borrowed stock back at the lower price and return it to your broker to close the position; your profit would be the difference between your initial sale of the stock and the price at which you closed your short (minus commissions and other applicable fees).
The risk comes if the stock rises, because you’d then have to buy back the stock at a higher price and return it. Buying stock back at a higher price means you are taking a loss – and because prices can go up with no ceiling means your losses can technically be unlimited – it costs you whatever it costs to buy the stock back and return it to the lender when called on to do so.
Now let’s take this to a larger scale: when a group of investors on Reddit (an online social news platform) started bidding up GameStop and other “meme stocks,” the “shorts” rushed to buy back their shares and cap their losses. This “short covering” drove the share price higher, forcing other shorts to cover, driving the share price higher still, and so on.
That’s the definition of a short squeeze, and it inflicted heavy losses on some hedge funds. As of January 28, the “shorts” were down some $70 billion, according to Reuters.
Market correction ahead?
The biggest worry among investors is that this episode, combined with the fact that the S&P 500 and TSX Composite Index were trading near record highs as of this writing, despite the effects of the pandemic, signals that stocks are overvalued and could be headed for a correction.
To speak to that concern, we asked BlueShore Wealth and Credential Securities Investment Advisor Ilana Schonwetter to share her thoughts. Her response was unequivocal: “The answer is no,” she says. “This is a very isolated phenomenon.”
She feels that, if you’re investing for the long run, you should continue to do so. “In my 26-year career, I’ve heard many times from people who want to sit on the sidelines because they’re worried the market is overvalued. Twelve or 18 months later, when the market has risen further, they’re usually still in cash and have missed the gains.”
A simple way to reduce market anxiety
But if you are still concerned about a pullback, Schonwetter offers a strategy to lower your stress level: dollar-cost averaging.
The beauty of this approach is in its simplicity: instead of investing all of the funds you plan to put into stocks at once, you invest fixed amounts at fixed times.
Here’s a hypothetical example: say you plan to buy $500 of stock ABC at the end of every month throughout 2021. On January 31, the stock trades at $36, so your $500 gets you 13 shares (not including fractional shares and trading fees).
Now let’s fast-forward to the end of May. By that time, let’s say there’s been a correction and the stock has fallen to $25. That means your $500 buy for that month gets you more shares (20, in this case), due to the lower price.
Over time, you’ll buy more share when company ABC’s price is lower and fewer when the price is elevated. Assuming the stock continues to rise in the long run (with the usual ups and downs, of course), your average purchase price would be lower than that of an investor who held off until later and bought all at once.
Trading platforms in the spotlight
Aside from the hedge funds and the investors betting against them, there’s a third actor in this drama: the trading app Robinhood, which was the primary channel through which investors bought GameStop and the rest.
Robinhood’s value proposition is that it lets investors trade commission-free. It doesn’t operate in Canada—at least not yet.
However, Robinhood still profits from users’ trades by charging market makers—firms that constantly buy and sell stocks to ensure sufficient numbers of shares are available to fulfill investors’ orders—a small fee.
But you also probably heard that Robinhood limited trading in GameStop and other meme stocks for a time. That was because the app faced big requirements from its clearinghouse—essentially, they required Robinhood to put up the money to cover its clients’ trades until they settled. Because of the high number of stock trades users were conducting, Robinhood was unable to do so.
This part of the story threw into relief the importance of the strength of the brokerage you’re using if you’re a self-directed investor—something investors using Canada’s major financial institutions, including the Qtrade Investor online-brokerage service offered through BlueShore Financial’s investment partner, Credential Securities, don’t have to worry about, as they have the resources to cover users’ trades.
Nonetheless, the episode will likely prompt investors to more closely scrutinize their brokerages—a positive for both investors and the investment industry.
DIY, robo- or full-service advisor: which is best for you?
Finally, stories like this are a good reminder to review your portfolio and identify whether your current approach is working for you.
For example, if you’re a beginning investor, you may feel you can manage your investments yourself. And that might be true, but bear in mind that successful investing involves expertise and time to properly judge a company’s health and potential.
Nonetheless, if you have the time and interest, a DIY approach could serve you well.
You may also consider a “robo-advisor,” which will invest your funds in a pre-designed portfolio based on your goals and risk tolerance. The algorithm then rebalances the portfolio over time as the value of the investments within it fluctuates.
Robo-advisors are a good option for investors with small sums to invest, or those just starting out. Our VirtualWealth® platform is a hybrid robo-advice service, which enhances the automated model with a “live” advisor who can help guide you as your needs change.
But for those with larger portfolios and/or those investing money they plan to rely on in the future, going with a full-service advisor is still our recommended route. Our accredited advisors will help ensure your portfolio is properly diversified and provide other more personal or sophisticated advice a robo-adviser can’t, such as helping you minimize tax or maximize your estate.
An advisor can also provide a vital independent perspective, to help you stay focused during a market pullback and ensure you don’t make any damaging moves based on emotion, something that’s very easy for a DIY investor to do in the heat of the moment.
The last word
Finally, it’s important to keep events like the GameStop/Reddit drama in context, because that’s just what they are: momentary dramas that come and go, but generally have little effect on the overall long term direction of the market.
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