A Letter To Young Investors On This Market Frenzy

Dear Young  Investors,

This stock market has been fascinating, exciting, and mesmerizing, but I fear a trainwreck is coming. When GameStop’s stock value rises to $34 billion from nearly $279 million a year ago, and its fundamentals are still weak, this move is not rational. I want you to understand why and I have tips to share to minimize risk. There appears to be no reason for this stock to climb as it had. None of the analysts or the company management are signaling a positive change.  

 Market frenzy is not new, but the Reddit forum, Wall StreetBets, and its influential power are a way of making recommendations. This new tactic may pose significant risks, not just to the hedge funds but to the marketplace itself. Already we have seen fallout such as Melvin Capital. This hedge fund lost 53% from its short-selling in January. They are a professional firm that should understand the perils of short selling.

My sympathy and concern lie with the young and inexperienced investors. They may lose their motivation to invest for lack of trust in the financial markets. I applaud the higher participation of young retail investors and hope for their investing success. We explain what is happening and provide helpful investing rules and tips to minimize risk later on in this letter.

Higher Retail Participation

 I have a gray hair or two, but in my experience, I have not run across the message board and retail traders recommending aggressive purchasing several out-of-favor stocks (GameStop, Koss, AMC, American Airlines) to the moon. Social media’s influence on the financial markets, specifically Reddit WallStreetBets, and now the more than six million members, powered several stocks–Bed Bath & Beyond, Koss, GameStop, AMC–to extraordinary heights as these companies’ fundamentals remain poor.

The Reddit forum peppers its board with new Wall Street lingo. Terms like “yoloed a stock” translates to  “you only live once.” It means that you should make a significant investment in that stock. For more on traditional Wall Street jargon, you can read our post here.

Who would have thought we would see such volatility in Gamestop and other stocks as retail traders rage against hedge funds in positions of the longs against the shorts, the traditional vs. new breed in this David vs. Goliath saga. I am sure some institutional investors are riding this horse alongside the retail traders. 

Is there stock manipulation in this activity? Stock manipulation occurs when there is artificial inflation or deflation of security prices for personal gain.  I don’t know that anyone would be surprised if that is happening. I am sure the SEC, and its eventual head, Gary Gensler, are watching closely. 

How Will This Market Frenzy End?

Who or what is responsible for the market frenzy, and how will it get back to normal, if ever? We have seen this story with different stock names before, and we will see it again. It will be a learning experience. There will be books to explain it with hindsight and at least one movie to entertain and educate us. “Wolf of Wall Street” will pale next to this new story.

I will try to explain what is happening and make sense of it, although it is a moving picture. I will always encourage you to understand the stock market, its risks, and how to reduce them. You need to invest responsibly. Investing remains the best path to wealth.

In recent years, the industry changes have seen new entrants like Robinhood enabling young and inexperienced retail investors to access the financial markets. Is Robinhood the villain or the victim? They have had to raise substantial capital to facilitate activity.

Increased retail participation is a good thing, but investors need to understand the market risks and use financial discipline. 

As an investor and an ex-Wall Streeter (I was an equity analyst at Drexel Burnham and UBS), I have seen my share of events (e.g., Long Term Capital, dotcoms, WorldCom, and subprime mortgages) that caused extreme market volatility. Financial markets are regularly subject to volatility, but the (GameStop) frenzy seems quite different and more extreme. People always get financially hurt, sometimes devastating so and this time will not be an exception.

GameStop

The astronomical rise to an irrational high of $483 (thus far) in GameStop (GME) in January 2020 was surprising given its rational $4.21 stock due to its poor fundamentals. Comparisons to Blockbuster in the then-emerging Netflix era are apt. GameStop, brick & mortar retail business selling video games and consoles during COVID, is not a recipe for success. My teen son downloads his games now. GameStop was once our favorite destination, but that was years ago.

A year ago, the shares traded at $4.21 per share with a $279 million market cap. With its fundamentals declining, GameStop has been a target for short-sellers, notably by hedge funds. Reddit forum has driven stocks to record levels initiating short squeezes (explained below) on institutional investors. Quotes from WallStreetBets are helpful to understand the movement to affect stock prices. 

This frenzy is more significant than the GameStop action, which has spread like a contagion to several other stocks, including AMC, Bed Bath & Beyond, American Airlines. Stock and options traders, many Robinhood customers, have collectively used their influence via WallStreetBets, a Reddit forum, to support GME’s price.

Since the start of 2021, GME has been hugely volatile, going up 600%. According to S3 Partners, short-sellers have lost $5.05 billion, resulting from short squeezes. Let me explain these terms, so you can better understand short-selling and short squeezes.

Short Selling And Short Squeezes

Traditionally, when you buy a stock, you hope the stock up above your purchase price, and you have a profit. Short-selling is a bet that the stock will decline, and you will buy the shares by borrowing the shares, speculating you can buy them at a lower price in the future. It is an advanced strategy and should be done only by experienced traders who will hedge with call options.

A short squeeze occurs when a stock, like GME, rises sharply, forcing short-sellers, who expected GME to fall, to have to buy shares to minimize their losses. If many traders are doing the same thing, it places upward pressure on the stock price.

Hedge funds heavily shorted GME. Its short interest was $5.51 billion, up from $276 million a year ago. The percentage of GameStop’s float (e.g., regular shares available to trade) sold short was 139.57%! That is an obscene number. The GME situation is ongoing, pinning the WallStreetBets traders against hedge fund companies or David against Goliath (the hedge fund companies). The facts are not fully known.

Even My Daughter Gave Me Advice

What was scary for me was a conversation I had with my daughter, Alex, this week. Alex is bright, a terrific student, but she doesn’t know much about the stock market or care. She surprised me when she asked if I owned any shares of GME or any of the pumped-up stocks. When I assured her that I didn’t, as she turned from me as if I were a loser, she said, “But, Mom, you could have made so much money!!!!” I love making money, but I do try to limit my risks.

So, this letter is also for my kids, Tyler and Alex, my college students, and of course, my readers!.

How Did We Get Here?

 

The Democratization of The Stock Market

More retail investor participation in the financial markets did not happen overnight. The household distribution of US stock ownership has been unequal for a long time. 

According to US Census, in 1952, only 4.2% of the US population owned common stock. A 2020 Gallup Poll reported that 55% of Americans hold stocks, but the ownership is mostly the wealthy. Based on net worth, the top 1% own the vast majority of stock market value at 88.1% as of 4Q2019.

In early 2020, with market downturn associated with coronavirus, many young first-time investors signed up for new accounts at online brokers, traditional and Robinhood. That trend of increased young investor participation will hopefully continue unless the GameStop phenomenon ends badly.

Reduced Barriers To Entry

There have been reduced barriers to entry driven by deregulation, technology, reduced cost, and increasing competition. Competition emerged first in the brokerage industry with discount brokers and online brokers.

Robo Advisors

The rise of smartphones drove investors to innovative and disruptive digital services. Robo-advisors such as Robinhood are investment management companies that use computer-generated algorithms and potentially human-based advisory services to develop a stock portfolio. Their products are stocks, funds, options, gold, cryptocurrencies, all available at zero commissions, lower management fees, and no-to-low minimum requirements.

They serve young and first-time investors with easier access to low-cost investing via trading apps on an equal playing field. These fintech companies have fully digital platforms with easy to use interfaces, sophisticated trading tools, and research resources.

Robinhood

With at least 13 million customers, Robinhood is among the largest online investment platforms for stocks, options, and cryptocurrency trading. They don’t require their customers to have a minimum of money in their amount, so they cater to all people, not just the wealthy.

Robinhood attracts scrutiny from the SEC, Congress, and the public. They have increased their educational resources for beginning traders and investors. It is not clear how effective that will be in reducing risks associated with speculative trading.

Their average customer is in their mid-20s, with significant Millennial representation. Due to the madness occurring in the markets, Robinhood has restricted transactions in several stocks to closing positions only and raised their margin requirements as of this writing. CEOs Vlad Tenev and Baiju Bhatt asserted that many of their customers use Buy and Hold strategies with a long-term perspective.

Are Young Investors Taking On Too Much Risk?

Retail investor participation has grown in recent years. Many people began investing during the lockdown as sports, entertainment, and gambling establishments closed.

As a college professor, I encourage my students to begin investing in the market through the Stock Market Game. Some already have Robinhood accounts and are trading stocks, options, and cryptocurrencies. Investing in stocks, which typically generate higher returns than bonds, is the best path to achieving wealth. Higher returns come with higher risks that you need to understand to mitigate those risks.

8 Tips For Young Investors

 

1. Get Your Finances In Order First

Never invest money in the market you can’t afford to lose. Before investing, make sure you can keep your lights on by paying the utility bills. Your finances should be sufficient to cover your necessary living costs for a reasonable time. Don’t use your rent money to trade or invest. Instead, set some emergency money aside.  

2. Can You Explain Your Strategies?

Don’t take wanton or reckless risks by engaging in strategies you don’t understand. I know people have FOMO (fear of missing out) when they see their friends make a ton of money by adding many risks. Learn through YouTube Channels and resources available to you to understand the downsides in any stock trading or investing.

If you bought X stock, could you explain its fundamentals and why it is attractive at current valuations to a friend or colleague? I am talking about a 30-second pitch, but it is good practice to know why you are investing.

3. Don’t Use Leverage Through Margin Buying

Buying or trading stocks on margin is a significant risky move. When buying shares in a company, you may use some of your own money and borrow the rest from your broker.  People use margin buying to make higher profits through the added leverage. By paying only a small portion of the total amount, investors amplify their purchasing power. However, it doesn’t always work in your favor.

Essentially, you are borrowing money or using leverage to pay for your investment. Margin calls are an extension of credit, with your securities acting as collateral. Typically, you can borrow up to 50% of your intended investment, and your broker has a 30% margin requirement, although it can vary.

A Margin Requirement Example

Mary will borrow $25,000, buying  $50,000 of stock ABC. Under normal circumstances, If ABC drops 30% to $35,000=($50,000 x .30). Mary’s equity is now  $10,000 = (35,000-25,000 borrowed). Her broker’s margin maintenance requirement of 30% rears its head, meaning Mary needs to have $10,500 in her account= (35,000 x .30), requiring her to add $500= ($10,500-$10,000) for the margin call. 

The risks you may face are largely out of your control. When the market becomes volatile, brokers may raise margin requirements to as high as 100%.  A few brokers, including Robinhood and Interactive Brokers, raised margin requirements to 100% on specific volatile stocks like GameStop and Bed Bath & Beyond. You either can satisfy their requirement or sell the shares. If your stock has plummeted, and you don’t have the liquidity to meet the margin call, you must sell the shares.  

4. Short-Selling Is Complicated

For experienced traders and investors, short-selling has its merits, but there is no place for inexperienced traders or investors. A stock’s value may decrease for many reasons, including lower revenues and profits, product failures, or increased competition. Short-selling has been in the press, especially related to GameStop, which has a very high short interest and brought out a swarm of retail traders who have sent GameStop in the opposite of where the short-sellers want it to go. Watching the market volatility reminds me of the dangers of short-selling and margin buying strategies.

A short sale of a stock involves selling a stock you don’t own. Therefore, you have to borrow the shares to sell them on the market, speculating that the share price will decline. The short seller must replace the shares at a later date. As you borrow the stock for the short sale, this trade requires margin, but it requires a higher amount because there is no collateral, as we discussed.

The Fed requires all short sale accounts to have 150% of the implementation’s short sale value. This percentage is a minimum, but the broker can adjust the requirements upward.

An Example of A Short Sale

Let’s say you believe GM is overvalued at its current price of $35. You’ve done research (hopefully!) and found out the company will generate lower revenues than the consensus believes due to potential product recalls. You call your broker and arrange to borrow 100 shares of GM at $35, or $3,500 selling price, and the broker sells those shares.

A few months later, GM shares drop to $27, so you instruct your broker to purchase 100 shares at that lower price, or $2,700. These latter shares are given to the brokerage firm to repay the borrowed stock.  You pocket $800, or the difference between $3,500 and $2,700.

A Short Squeeze

This example is simple and straightforward. Imagine a transaction with GME and shorting 10,000 shares at $5 per share, or $50,000, expecting GME to go to $3 per share. Instead, GME shoots up to $300 per share, and days later, it is worth $3 million. There have been instances of short selling disasters. For example, when a company gets a higher buyout which lifts its shares. The GME situation is different for the messaging boards and how the traders collectively pushed up several companies’ stocks.

Use Call Options

Short selling is not for the faint of heart. You can limit your risks by using call options to hedge against a possible rise in the stock. Without an option, you are opening yourself up to unlimited losses. Targeted hedge funds (e.g., Melvin Capital) lost billions on GameStop, and they have experience. What makes young traders believe that they can handle these risks?

I have not engaged in short selling, which would mean I would want a stock to go down. However, some short-sellers provide valuable insights by uncovering stocks that may be overvalued or fraudulent. Short-seller Jim Chanos haunted the shares of Enron in 2001 by uncovering Enron’s accounting scandal.

Day Trade Is Challenging

The stresses of day trading are very high. Traders rapidly buy and sell stocks throughout the day, hoping to make more profits than losses. Unfortunately, many make more losses at first. They tend to borrow money, buy money on margins, and requires access to capital.

There is a low chance of success in earning an income as a day trader, yet it is a challenge to do this only on a part-time basis. It may sound exciting as you can do it from your home, but there are costly technology needs and a good stomach to handle the pressures. Swing trading is an alternative that has some similarities to day trading but is usually is done over a more extended period and not your full-time job.

When the market gets volatile, don’t bail by selling all your stocks. 2020 was an extraordinary year for many reasons. It was a year in which the stock market proved its resilience.

From its February peak to  March 23rd bottom, stocks dropped nearly 34%. However, the S&P 500 index resulted in a 16% gain for the year and a 44% gain for the NASDAQ. Imagine if you sold your shares on March 23rd?  Many people did sell, learning a lesson about holding on to stocks during market volatility.

5. Buy And Hold Strategy

I am not a short-seller and don’t use leverage or day trade for fear of taking on too much risk. I have made some poor choices through the years, such as selling stocks too early, being too greedy, not having enough patience, or buying a stock I didn’t understand. My investment strategy is more deliberate buying and holding onto fundamentally strong stocks for the long term.

This strategy has some advantages like compounding, lower capital gain tax rates, and waiting out the turbulence and dips, or buying more stock for dollar-cost averaging to reduce my basis. Compounding is an excellent tool to grow your wealth in retirement and taxable accounts exponentially. That said, you do need to use financial discipline. 

6. Take Some Money Off The Table – Don’t Be Greedy

It is a good idea to sell some stock to lock in a 20%-25% gain. I have learned the hard way, watching my stocks climb as if going up were inevitable, losing money in dotcoms and elsewhere. The old Wall Street saying remains close by with these words, ” Bulls make money, bears make money, pigs get slaughtered.” If you have some big gains from GameStop, you probably want to lock that in even if you will pay the higher tax rate.

On the other hand, if a stock is not working as you thought, it may be time to admit a mistake. Consider limiting your losses by selling the stock after it is down 8%. You want to revisit its fundamentals as something may have changed for the worse.  It hurts a lot when you see a bigger loss in a stock you still own. Often, cognitive biases, such as loss aversion, prevents us from giving up on one of our losers.

7. Diversification Minimizes Risk

Concentration in one stock is risky. What if you yoloed, and put a significant amount of your money in GameStop, and it suddenly dropped precipitously. It did that when Robinhood restricted GME and other stocks but removed the restriction when they received criticism. If not GameStop, it could be another stock name that becomes angel but then loses its wings.

Diversify your portfolio is a way to minimize risk. I buy stocks outright, but I remain diversified by buying index funds and ETFs. As you build your wealth, you should make sure you have diversified with other assets, including money markets, bonds, real estate, and gold. 

8. Don’t Gamble Or Speculate Without Some Knowledge

Investing in the markets is a way to use your earned money to make more money than you lose. Don’t gamble your hard-earned dollars on anonymous tips or speculate without trying to understand its risks and rewards.

As I wrap up this letter, I believe you can find success in investing and find ways to make it fun and rewarding. Don’t get sucked into strategies that won’t benefit your finances. As you make more money, you can use your generational influence to make societal changes through work and charity. You don’t have to make money to do good in the world. Don’t get discouraged when you lose money. Make that a learning experience.

Final Thoughts

The unusual market activity prompted by social media-driven calls to buy stocks to counter heavily shorted stocks borrowed by institutional investors is dangerous. It serves as a reminder that investing is never a sure bet. There is a generational opportunity for young people to participate in the financial markets.

I hope that they are rational investors that use common sense and discipline to stave off potential losses. It will be a shame if these investors are vulnerable to losses and are mistrustful of the financial markets as some of these traders engage in possible revenge strategies.

Thank you for reading! If you found value in this article, visit us at The Cents of Money for other such reads.