What We’ve Learned From The GameStop Phenomenon
The story of David and Goliath was one of rich dad’s favorite stories. I suspect he may have seen himself as David, a man who started with nothing, yet rose to compete against the giants of the business world.
Rich dad said, “David could beat Goliath because David knew how to use the power of leverage. A young boy and a simple slingshot were far more powerful than the feared giant, Goliath.”
Right now, there is a war between the Reddit Warriors, or “Davids” and the giant hedge fund WSB who is financed by those who have trusted the hedge fund with their retirement plan.
Unlike the traditional story of David and Goliath, the Reddit Warriors are individual investors who are most likely going to lose everything. These little guys are buying a stock at $100, $200, $300, even $400. It’s a worthless stock because GameStop, as a company, uses an outdated business model with horrible fundamentals, thus, no value.
I understand by buying these stocks the Reddit Warriors are trying to punish the hedge fund and teach Wall Street a lesson, but even if they take down this hedge fund, there are hundreds if not thousands more.
Do they think they can take them all down?
Let me explain what is going on here. The hedge fund is shorting the GameStop stock. What does that mean? It means they think the stock is overvalued. So, they short it. A short wins by selling a stock (GameStop) and profiting from the stock’s decline.
Let’s begin by looking at three important facts of taking a short position:
- You are going to position yourself to make money on something that is falling in value.
- You are going to sell something that doesn’t belong to you.
- You are going to change the order of buying and then selling—to doing the exact opposite. In other words, you are going to sell something first and then buy it later. (I don’t know about you, but this made my brain freeze up when I was first introduced to this concept. But there was a large part of me that wanted to understand this. I was interested to see how investors could take such a position and profit from it!)
In the example of GameStop, the hedge fund does not own the stock they are selling.
How is this possible and why?
First, they borrow the stock from a broker (that is the ‘How’). Why?
Because they believe the stock price will drop. Once the stock price drops, the hedge fund buys the shares that they owe the broker. But now they are buying the shares at a lower price.
So, the hedge fund returns the same number of stocks to their broker that they borrowed. They have satisfied their obligation to the broker.
The hedge fund’s profit is the delta between the original stocks they sold and the new, lower price of the stocks they purchased and returned to their broker.
Now, before you run out and try this strategy, remember that if you short a stock that pays a dividend, you must pay that dividend as long as you are owning the stock. Of course, if there is no dividend, there is no concern.
While this sounds like a safe strategy there is a danger.
What happens if the stock price goes up?
Now the hedge fund has to buy the stocks at a higher price and return the higher-priced stocks to the broker. In that case, the hedge fund loses the money from the delta of the price they borrowed the stocks and the higher price they purchased them at.
Why doesn’t the hedge fund just hold on to the stocks until they do fall?
Their broker won’t let them. After the hedge fund has lost a certain amount of money, the broker can demand that the hedge fund sell their stocks and repay the broker or place more money in their account with the broker; this is to cover the loss they are potentially going to have when they purchase the higher-priced stock. It is the way the broker protects itself. So, the hedge fund is forced to place more money in the broker’s account. This now makes the risk and danger to the hedge fund even higher.
Now, if the Reddit warriors keep forcing the GameStop price to go higher, the hedge fund must keep adding money into the broker account or abandon the game and lose a ton of money. It’s a game of chicken. Will the hedge fund run out of money before the Reddit Warriors or will the Reddit warrior community run out first?
The sad part is either way the uneducated investor loses. If the hedge fund loses the fight, all their customers, all their 401(k)’s go bust. All the retirement plans they manage go bust and thousands or possibly millions of people are left with nothing to retire with. All the people who trusted this hedge fund with their money could end up working until they die or become homeless.
But, what if the Reddit warrior community runs out of money?
The stock price can’t keep rising indefinitely because the stock itself is worthless. While the hedge fund wins, all those uneducated investors who thought GameStop was a good investment lose their shirts. They potentially placed all their money in this game of chicken and suddenly lost everything. If they purchased GameStop stocks at $100, $200, or $400 and they drop to zero, they lost a lot of money and many of them will lose all or at least a lot of their money.
What Can We Learn From The GameStop Phenomenon?
I’ve talked for a long time about the importance of control when it comes to investing. Control is the most important thing you can have as an investor. Lack of control leaves you at the mercy of market conditions. This is also why I say it’s riskier to be an employee than to be an entrepreneur. As an entrepreneur, I have more control over my destiny than I do as an employee.
One of the best ways to tell if someone is a sophisticated investor vs. an amateur investor or gambler is whether they understand how to set themselves up for the most control.
In this sense, both retail investors and hedge funds are amateurs and gamblers. This GameStop mania was a perfect lesson in the importance of control. Make no doubt about it, the retail investors stuck it to the hedge funds. But a reckoning will most likely come to most of those retail investors and probably at the hands of the hedge funds.
Rather than get caught up in gambling to make a fortune in day trading, I’ve taught for years about how to build true wealth as a sophisticated investor.
If you’ve been thinking of jumping into the fray and making a quick buck on what’s happening in the market, I’d encourage you to think and ask yourself if you really want to be a gambler, or if you’d rather commit yourself to become a sophisticated investor who intelligently builds wealth over time.
Editor, Rich Dad Poor Dad Daily