A standing ovation to all young investors who are engaging with the markets. I am thrilled you are here.
Story originally posted January 2021
It was only a few years ago that “the experts” worried you would never embrace investing, particularly millennials who watched their parents struggle through the Great Recession and lose years of savings in their stock portfolios and 401(k)s seemingly overnight.
So welcome! The market will benefit from your unique perspective and engagement.
I have spent my career educating and encouraging lay investors and wholeheartedly agree with the great Peter Lynch, who said, “Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.”
The ability to access free research and trade essentially without cost has democratized investing. This is good for everyone.
But let us not forget there is a difference between speculation and investing. Both have their place. But speculative bubbles eventually burst. They just do.
So a note to the Redditors out there: Speculating to stick it to the Hedge Fund Man may come with a hefty price tag.
But let me step back for a moment. I came of age in a simpler time, when revolutions were launched via rock ’n’ roll lyrics rather than stock options and an app. The Beatles championed insurrection against The Man in their iconic song “Revolution”: “You say you want a revolution well/ You know we all want to change the world.”
The Founders and the Beatles understood that a revolution could be a necessary evil. But revolutions can also be fraught with peril.
Reddit and GameStop
GameStop (GME) is the poster child for the current speculative peril. On a trailing one-year basis, the stock is up 8,154%. And in January alone, it has climbed around 1,700%. But why?
The company planned to close 1,000 stores in the fiscal year that ends Jan. 31, and it aims to close more stores in the coming year. And it is likely to announce a third straight year of losses. That’s hardly an inspirational story if you’re concerned about a company’s financial fundamentals, or a justification for the meteoric rise in the stock.
The reason the stock price has skyrocketed is due primarily to the purchase of call options catalyzed by a Reddit message board collaboration of retail investors who wanted to squeeze hedge funds who were short the stock.
Reward and risk of options
Options have a place in many portfolios. But they can be risky instruments depending on the market environment. Option trading volumes were up over 50% between 2019 and 2020, according to research published by Piper Sandler, and a record number of these options have been attributed to the retail investor. Short-dated (two weeks or less in this example), far out-of-the-money options are a trademark of retail investors because they are inexpensive to buy, and yet they can skyrocket in value if the underlying stock makes a move.
When an investor or speculator purchases a call option, the market maker behind those contracts limits their own risk by buying the underlying stock to protect against having to deliver that stock in the event of a sharp rally. The more contracts that are purchased, the more stock must be purchased to hedge the market maker’s risk. This can escalate a rally in the stock and options pricing and can quickly result in a virtuous cycle, driving the stock price ever higher and, voila!, squeezing the shorts.
That is, until the music stops and traders turn their attention to another stock. When that happens, look out. The reverse trade can quickly result in epic losses.
GameStop hogs get slaughtered?
In my 30-plus years as an investor, I have seen entire firms obliterated by excessively risky trades and plenty of individuals who day-traded their portfolio to zero. When the stock price becomes divorced from any modicum of fundamentals (great product, dominant franchise, rapid growth), individuals are speculating not investing. Better to gamble in Vegas, where you can pick up a show and a few drinks after you hit the tables.
The Beatles song continued, “You say you got a real solution/ Well, you know we’d all like to see the plan.”
Just punishing short sellers may be a strategy, but not a plan.
Invest in companies you understand, companies who build great products or technologies, companies that pay growing dividends. If you must speculate, limit your exposure to a modest portion of your portfolio.
Establish a discipline to ensure you continue to prosper. According to a report by the Harvard College Consulting Group, 82% of young investors who lose money have no investing strategy; 71% of those who generate returns employ a discipline.
Today’s trading limitations imposed by Robin Hood and other platforms are controversial and counter the idea of a free market. Changing the rules of the game during halftime doesn’t sit well with any freedom-loving investor.
Boring is good in stocks, and you have plenty of time to watch your portfolio double and double and double again. The markets are risky enough without undue speculation.
There is some wisdom in the old saying: Pigs get fat, hogs get slaughtered.