Unless you’ve been living under a rock, you’ve probably heard talk about how Reddit trolls are getting rich investing in GameStop and causing Wall Street fat cats to lose billions. While all of the GameStop drama is riveting, it can also be quite confusing for anyone who isn’t a finance nerd. To help you figure out what’s going on with GameStop so you can enjoy the drama as much as the rest of us, I’m going to simplify the financial concepts that caused Wall Street investors to lose billions, tell you why this battle is such a big deal, and answer the biggest question of all. Should you invest in GameStop?
The GameStop War
If you’re unfamiliar with GameStop, they’re a brick and mortar video game retailer that can be found in shopping centers and malls around the world. But they’ve been on the struggle bus. The pivot toward online shopping, the rise of streaming, and the ease of downloading a video game directly to your console has made GameStop’s future as a brick and mortar retailer look pretty grim. The pandemic didn’t help them out either.
While most investors would avoid buying stock in a failing company like GameStop, these companies can be a gold mine for hedge fund investors.
What is a Hedge Fund?
A hedge fund is an actively managed fund that uses pooled funds, typically from accredited investors, to try and take advantage of certain identifiable market opportunities. In simpler terms, they take money from rich people and try to find opportunities in the stock market that others don’t see and capitalize on them. One way that they do this is by short selling.
What is Short Selling?
Typically when people invest in a company, they think the stock price will go up and take what’s called a long position. They buy the stock at its current price and expect that they will be able to sell it at a higher price in the future. The difference between the low price they bought the stock for and the high price they sell it for is the investor’s profit.
Short selling does the opposite of this and bets that a stock’s price will go down. It’s slightly more complicated than a long buy and works like this.
Ruth thinks a stock’s price will go down, so she borrows that stock from Janet and immediately sells it to Donald at its current price of $100. Then Ruth waits for the stock price to drop to $50, buys the stock back from Donald at the new low price, and then gives the borrowed shares back to Janet. Since Ruth sold the shares to Donald for $100 and then bought them back for $50, she makes a $50 profit.
While short selling is only slightly more complicated than the long buy strategy investors typically use, it is much riskier. Unlike regular investing, where you can only lose the amount of money you initially invested, there is no limit to the amount of money you can lose from short selling.
A short seller loses money when the price of the stock they invested in goes up. Since there is no limit to the height that a stock’s price can rise, there’s also no limit to the amount of money a short seller can lose. This extreme downside risk is what allowed Reddit investors to buy GameStop stock and create billion-dollar losses for hedge funds.
What Went Down: The GameStop Short and WallStreetBets Rise
In 2020, hedge fund managers took notice of GameStop’s grim future and aggressively shorted the stock. If GameStop failed, the hedge funds stood to make a killing.
This aggressive short position didn’t go unnoticed by individual investors on Reddit in a group called WallStreetBets, though. They realized that if they bought up as many shares of GameStop stock as possible, they could drive the stock price up. Hedge fund managers would then be forced to buy back their shares at a higher price to close out their short positions and avoid bigger losses if the stock price continued to rise.
To make problems worse for the hedge funds, the act of them buying back shares to close out their short positions actually pushes the stock price up further. This negative feedback loop is called a short squeeze. As the stock price went up, WallStreetBets investors made a killing, and hedge fund investors closed out their short positions at multi-billion-dollar losses.
Shifting Power from Wall Street to Main Street
As you can imagine, the hedge funds are not taking their billion-dollar losses lying down. They’re now calling for regulators to make it illegal for people to band together to create changes in the stock market like WallStreetBets investors did. But manipulating the market this way is exactly what hedge funds do when they short sell a stock.
When hedge funds take out large short positions on a company’s stock, this usually drives the stock price down further and more quickly. So hedge funds are in the business of exacerbating problems at already struggling companies and causing them to fail more rapidly. The faster they go down, the faster the hedge fund makes money.
So are hedge fund managers just mad that everyday investors found a way to beat them at their own game? Probably.
That’s because hedge funds are typically only accessible to accredited investors. To become an accredited investor, you must meet certain income and net worth requirements. This prices out most regular investors like the ones on WallStreetBets.
The benefit of becoming an accredited investor is that you can invest in a wider range of investments. Because of your wealth, the SEC assumes that you’re able to take on the risks associated with investment categories that are less heavily regulated by them. Being accredited also allows investors to take riskier positions like selling a stock short.
Regular investors, on the other hand, are limited to investing in mutual funds. These funds are more tightly regulated by the SEC, usually only contain stocks and bonds, and investors are only able to take long positions in them.
So hedge funds are asking the SEC to increase regulations on everyday investors that are already limited to more heavily regulated investments, while the hedge funds benefit from the limited SEC regulation they face by only servicing accredited investors.
That’s why the GameStop short is getting so much attention. Because the power shifted from the mega-rich Wall Street investor to the everyday investor.
Should You Invest in GameStop?
I wouldn’t recommend it.
Investing in any singular stock is risky, and while all of the GameStop drama is super exciting, I’m much happier watching from the sidelines rather than being a player in the game.
There are always new shiny objects that pop up for investors. Right now it’s GameStop, last week it was Tesla, and we can’t forget about the rollercoaster ride Bitcoin has taken us on. But getting shiny object syndrome and investing in the latest hot stock is a great way to lose money in the long run. Not to mention, it’ll elevate your stress to the max.
The easiest and most hassle-free way to invest in the stock market is to invest in passive funds. These include index funds and ETFs that track an underlying set of investments. Their goal is to receive the same return as the market, and since the market has historically gone up over the long term, it’s safe to assume that you’ll make money investing in them.
Passive funds also usually have lower fees than actively managed funds like hedge funds or other mutual funds. That’s because active funds try to find hidden gems like GameStop so you can make sky-high returns. Finding hidden gems takes a lot of work, though, and you pay more for all of that extra work.
Paying more in fees may not seem like a problem since your fund manager says they’ll make you more money, but active funds often don’t actually provide higher returns to their investors. I mean, think about how much money those hedge fund investors just lost. Now they’re stuck with huge losses and high fees. Not a spot I want to be in.
If you’re looking to skip the drama and invest in passive funds, a great way to get started is to invest in one that tracks the S&P 500. The S&P 500 is widely regarded as the best measure of the overall stock market’s performance and tracks the 500 largest US companies. Funds that track the S&P are super common, well-diversified, and have low fees, which make them perfect picks for almost any investor.
Who the victor will be in the battle between the hedge funds and the WallStreetBets investors is still unknown. Will the rich, Wall Street tycoons take back their power and crush the everyday investors? Or will David prevail against Goliath and leave the WallStreetBets investors on top? Who knows. One thing is certain, though, watching the drama continue to unfold will be one hell of a ride.