The stock market has grabbed headlines in recent weeks, though not for normal reasons.
Rocked by unconventional fluctuations, many American investors and spectators have learned terms like shorting, Reddit and GameStop.
That has all happened because hedge funds, with the most widely known being Melvin Capital, bought stock in companies like GameStop, AMC Theatres and Blackberry Limited and bet against their success.
Those funds, which are essentially an investment partnership that often invests aggressively, bought shares in those companies in an attempt to “short” them.
When shorting a company, investors borrow securities in a particular company and sell them.
The goal is that those shares will drop in price, so when an investor purchases them back to return to the broker who they originally purchased the stocks from, they will make a profit.
“(Shorting is) the opportunity to buy the stock in the future at a lower price, which means you’re betting the stock price is going to go down,” summarized Dwight Schaefer, president of Schaefer Wealth Management in Waterloo. “Basically, someone who is shorting a stock is hoping the company’s value will go down so they can make money.”
For the hedge funds attempting to short those companies, the plan did not work.
It started after users on Reddit, a social media site for news aggregation, web content rating and discussion, noticed what the hedge funds were attempting.
Curtis Haentzler, an Edward Jones financial advisor in Waterloo, said as early as last year people posted on Reddit about the effort to short the stocks in question.
“It started with a really good, fundamental analysis,” Haentzler said. “I read the whole thing, and it was really good. As more people came on, it was less about the fundamentals.”
The problem, Haentzler said, was that hedge fund managers assumed businesses like GameStop would be a “Blockbuster 2.0” because they had an outdated business model.
What they failed to consider, however, was that GameStop had decent cashflow, a very popular magazine and new management.
“They still had good assets,” Haentzler said. “And the new management was making the right decisions.”
They also did not anticipate being beaten at their own game – largely by fairly everyday Americans.
As more and more people caught on to the posts on the subreddit, called r/WallStreetBets, they purchased stock in the companies the hedge funds were trying to short.
Eventually, people began organizing on Reddit and other social media sites to purchase more stocks or hold them in an effort to drive the prices “to the moon.”
“The root of it is the organization on social media, of just saying ‘we’re tired of not having the advantages of Wall Street and we’re going to try to get some advantages of our own and maybe teach Wall Street a lesson or two,’” Schaefer said.
The prices did rise – to levels beyond their actual value – but the hedge funds still owed on their borrowed shares so they had to buy them back, taking a loss and netting the Reddit investors a gain.
Melvin Capital had over $5 billion in losses, per reports.
Even for those who did not participate in buying any of the stocks in question, their investments may have been affected by the volatility.
The market overall went down even as GameStop, AMC Theatres and Blackberry Limited saw their stock prices skyrocket.
“Anytime you get short-term volatility in the market, it concerns people,” Schaefer said. “If they’re not working through an advisor and they’re doing stuff on their own, they might react emotionally because of the short-term volatility.”
Melvin Capital had to sell many of its assets to afford to buy back the stocks it needed, which contributed to some of that volatility.
“These hedge funds are so big that when they had to sell capital to cover their shorts, it affects all of us,” Haentzler said.
There has been some discussion of new regulations to prevent individuals from disrupting the stock market like this again, but Schaefer and Haentzler said some important lessons can still be gleaned from this situation.
If individuals would like to attempt some short-term investing, both men said to only use discretionary money.
“Anytime you want to do anything short-term like that, it has to be money you can afford to lose,” Schaefer said. “If you’re trying to get rich quick, so to speak, it better be with an amount of money you can lose because you’re speculating.”
Haentzler agreed, adding people should still consult with “someone in your hometown who is registered and knows what they’re doing” before making a risky investment.
For those who are more long-term investors, who want to see companies succeed to make a profit as opposed to see them fail to make money, Schaefer and Haentzler counseled patience.
“I always say, ‘focus on your long-term goal,’” Schaefer said. “You don’t want emotion to come into it with short-term volatility whether it’s this, an election, a pandemic.”
“In a situation like this, I might even ask my clients to invest more,” Haentzler added. “With anything else in life, when the price drops 25 percent, I’m happy about it. The stock market isn’t really different, even though it feels different.”