What happened this week?
Retail traders launched a coordinated effort to prop up the shares of struggling companies, using social media forums like Reddit. In particular, the goal was to expose the hypocrisy of large institutional investors, like hedge fund managers, who often make massive risky bets against the stocks of struggling companies (aka shorting), and then profit from the decline that follows when they often announce their bets publicly. In other words, blatant market manipulation.
What is shorting?
Shorting a stock is making a bet that its share price will decline from where it is today. The actual act of shorting involves borrowing shares at today’s price for a certain period of time. The investor then sells those borrowed shares with the idea of buying the same number of shares back at a lower price when they are forced to return those shares to the broker. If the price is higher when they are forced to buy the shares back, it becomes a loss to the investor. But if the price falls, the investor profits.
When a stock is “shorted” there is unlimited risk to the investor making that bet, as the price could theoretically increase forever and the more the price increases, the more the investor that’s shorting the stock loses. On the other hand, when you simply buy shares of a stock, your risk of loss is limited to what you paid, as the stock price can only fall to $0. By coordinating an effort to buy up shares of heavily shorted stocks like GME and AMC this week, among many others, this actually forced institutional investors with large short positions to “cover” their positions against these stocks by buying shares themselves, which further accelerated the wild share price increases we have been seeing in the media. This is known as a “short squeeze” and it caused some major losses to the Wall Street firms taking this high level of risk.
In response, several brokerages restricted certain types of trades and lowered margin limits on their platforms – Note: trading with margin is essentially borrowing money to buy stocks, using your account as collateral. Most notably, the free trading app, Robinhood, received enormous backlash for not allowing users to buy shares of these specific stocks for an entire trading day. This action was seen by many as a move that catered to the very Wall Street institutions being harmed by the short-squeeze. Regulators, including the SEC, are investigating such claims and enforcement actions will possibly follow, if appropriate and necessary. But the other side of this and the explanation provided by the firms themselves, like Robinhood, relates more to the need to manage their own capital requirements and ultimately the risk to their users from the volatility of those stocks. The jury will be out for some time on this.
How does this apply to blooom and our clients?
At blooom, we focus on retirement investments and the types of accounts that act as retirement savings vehicles for our clients, like 401ks and IRAs. In particular, we’ve seen a lot of interest this week from our clients, asking our opinion on buying these particular stocks within their IRAs.
Our stance on trading individual stocks still stands.
Our general stance on individual stock holdings is that they should be kept to a minimum when we’re talking about a long-term investment account with a goal like retirement and a specific globally diversified strategy in place. Holding shares of individual stocks requires an amount of constant and ongoing attention and research that most individuals do not have the time, interest, or the stomach for.
Our mission to democratize expert financial advice still stands.
Our mission at blooom directly aligns with, and fully embraces, the democratization of financial services. Retail investors have long been ignored, belittled, and exploited by Wall Street. This week’s events show the power social movements can have, but also remind us of the risks of trading individual stocks, whether you’re a hedge fund manager trading billions of dollars for your wealthy clients, or an average investor trading your own hard-earned money via an app on your phone.
Unfortunately, what often happens in events like this, where investing becomes somewhat of a game, is the smaller investors get left holding the bag, so to speak. While many retail investors have and will profit from this type of trading in the short-term, far more will be left in the dust and in financial ruin, likely to never trust the market again.
Day Trading vs. Gambling
Day trading stocks is not all that different from gambling. And gambling is not investing. There is nothing wrong with holding a small portion of your portfolio in a speculative, regularly changing basket of individual stocks, so long as you fully understand the risks and that that portion of your overall portfolio should generally be separate from your retirement accounts, in our view.
At the end of the day…
Access to participate in the wealth-building vehicle of the stock market is something that we firmly believe everyone should have, but goals, risks, and expectations of any particular strategy you’re using must be thought through carefully in advance of any investment activity, whether it’s short-term speculative trading, or a more long-term strategic approach.
The information is provided for discussion purposes only and should not be considered as advice for your investments. The information does not represent a recommendation to buy or sell securities. Investing involves risk. Your investments are subject to loss of principal and are not guaranteed. Investors should consider their ability to continue investing through periods of fluctuating market conditions. Please consult an investment advisor before you invest.
Published on January 29, 2021