Although we might only be in March right now, we may well have already witnessed what could be the investing story of the year. But even if it’s not, it will almost certainly be the most fascinating one from an investor’s perspective. We are of course referring to GameStop, that once seemingly doomed brick-and-mortar retailer that sells video games, consumer electronics and other gaming merchandise, and whose share price has experienced a hugely turbulent quarter thanks to a now infamous clash that emerged in late-January between Wall Street and a community of small retail traders.

Since those eventful few days, many have billed what happened as being something akin to a “David vs Goliath” narrative – but is that really accurate? And as investors, what are the most crucial lessons that we can take from this remarkable episode? These are important questions that we will address, but first, let’s briefly remind ourselves of what actually happened…

 

GameStop – a brief recap

As stated above, GameStop had been in a downward spiral for several years prior to January’s trading frenzy – a situation that was no more aptly illustrated than by its share price, which had fallen from around $33 at the beginning of 2015 to just $2.85 by April 2020. With such a huge proportion of its business focused on its physical presence rather than its online one, much of Wall Street had long-viewed GameStop as having a decidedly antiquated operating model.

The group “wallstreetbets”, which is a large community of independent retail investors on the social media discussion site Reddit, however, saw things differently. Many of its members began buying GameStop stock in earnest during last year’s final quarter, which in turn had helped to build up considerable bullish sentiment around the company that helped push the share price up towards $20 by year-end.

Upon noticing this bullishness and perceiving GameStop to be considerably overvalued, hedge funds began to short sell the stock in substantial quantities, a strategy which involves borrowing stock one does not own and selling it on the assumption that its price will fall, before closing out the position by buying back the stock at a lower price to lock in profit.

But having realized that GameStop was being widely shorted in this manner, the wallstreetbets community instead bought the stock en masse in late-January to drive up the price and inflict a “short squeeze” on the hedge funds, whereby those that shorted the stock would have to close out their positions by buying back at a much higher price and thus incurring huge losses. Indeed, the price rocketed up to a peak of $483 per share on January 28th (along with a handful of other so-called ‘meme stocks’ to a lesser extent including AMC Entertainment, Bed Bath & Beyond, Blackberry and Tootsie Roll). In doing so, the surge in price inflicted tens of billions of dollars of losses on those short selling funds.

At that stage, it certainly seemed as though David was “beating” Goliath, but just as the market commentators were readying their pens to compose such a narrative, those Reddit traders who were hoping the GameStop price would continue hurtling skywards ad infinitum (or “to the moon” as per the newly popularized phrase) saw the opposite occur as the price crashed spectacularly. By February 2nd, GameStop stock was trading at just $90 per share, before falling to $50 only 2 days later, meaning that those investors who had bought at sky-high prices ended up suffering painful losses.

The collapse seemed to be precipitated by a couple of key factors. For one, the decision by the massively popular trading platform Robinhood to restrict the buying of GameStop stock at a critical time when the price was significantly elevated prevented a huge chunk of retail investors from being able to access the market, which consequently forced a significant sell-off. And while some ‘wallstreetsbets’ members were signaling to the community to keep buying the stock, many were secretly selling huge positions at the same time to lock in enormous profits.

 

So, what can we learn from this?

A rare and astonishing occurrence like this has so many implications for the financial world, and as such, it offers up a myriad of lessons for investors to take away. Here are just some of the most important ones:

 

  1. Not everyone shares the same worldview as you

The GameStop chapter makes for an interesting case study in how the price of a stock can be viewed in such stark contrast by broadly different parties. For the hedge funds, they saw an overvalued company that was destined for a long-term downward trajectory; whereas those retail traders saw a company with a potentially bright future ahead of it.

“I believed the company was dramatically undervalued by the market. The prevailing analysis about GameStop’s impending doom was simply wrong,” the influential Reddit and YouTube trader Roaring Kitty told Congress in the aftermath. Was he crazy to believe this? Indeed, given that in recent days the GameStop price has experienced a resurgence following the news that it has made important hires to grow its online presence and reduce its dependency on physical stores, his view is at least partly justified.

The simple answer is that neither the Reddit traders nor the hedge funds were crazy in taking the positions they did. We all respond to financial information in different ways. And we all take decisions based on how we each perceive the way the world works. There is no objectively “right” or “wrong” response to market events.

 

  1. Be aware of the overall price of investing, not just the financial one

While no one who traded GameStop can be considered as crazy, one must ask whether anyone truly factored in the entire price of their trading positions? Successful investing is not just about the dollars and cents one spends to acquire a position. It’s also the volatility, the uncertainty and the fear that financial market investing continuously represents. All of these factors are easy to dismiss if one only thinks in purely financial terms.

The sheer fact that the price exhibited pronounced volatility (and continues to do so to this day), for instance, is something very few could have anticipated at the beginning of the year. Yet here we are today, discussing a stock that’s trading above $250, almost 100 times above where it was only a year ago. And during that time, many GameStop investors have been wiped out altogether, whilst even some hedge funds have lost billions of dollars with the likes of Melvin Capital losing 53% in January.

Did any of their models account for the volatility and uncertainty that has since transpired? Highly unlikely, it would appear. As such, it is worth remembering that there’s a price tag with every investment that goes well beyond just the up-front pecuniary factors. By identifying those factors, and by recognizing and acknowledging that they each represent a crucial part of the overall fee of participating in financial markets, it will go a long way towards determining your long-term success as an investor.

 

  1. Tail events are hugely significant to overall investor success

Of course, part of the reason why the events of late-January were not factored in beforehand was that they were virtually impossible to predict. As Robinhood CEO Vlad Tenev insisted when he appeared before Congress to explain the actions taken by his company, the extreme volatility of GameStop’s share price was a “1 in 3.5 million” event that made it impossible to anticipate in advance. “In the context of tens of thousands of days in the history of US stock market, a 1 in 3.5 million event is basically unmodelable,” Tenev said.

And yet those events have been more impactful for wallstreetbets investors, for the hedge funds, and for GameStop itself than at any other point in the company’s history. It was such a rare occurrence in the investing world, but nonetheless it will have created massive winners and losers.

Ultimately, this event highlighted the power of a “tail-risk” event in which the price of GameStop moved to such extreme levels that had an extremely low probability of occurring. And those extreme levels – whether around the $483 peak or after the subsequent price crash – were crucial in dictating which investors were successful, and which ones nursed huge losses.

Data from research and analytics group Ortex, for instance, estimated that by March 9th, those investors that had bet against GameStop shares were suffering year-to-date losses of $11 billion. And in just the week after GameStop hit its record high price, an estimated $36 billion had been wiped from the valuations of the five main ‘meme’ companies, meaning that a number of ordinary investors will have undoubtedly lost their lifetime savings.

Speaking to the Financial Times, one investor recalled moving his $69,000 Vanguard retirement account into GameStop shares when they fell to $230 per share on the Monday (1st February), but ended up realizing a $42,000 loss the next day as the stock price continued plummeting. “I built that…balance over a three-and-a-half-year period,” he said. “And in a moment of intense hype, in a moment of weakness for me, I messed it all up in a matter of a day.”

And that is invariably the nature of tail events. You could spend 99% of your investing life experiencing modest gains and losses that might well be significant to your overall wealth accumulation. But they won’t be anywhere near as important as the decisions you take during the remaining 1% of the time when a tail event unfolds and much of the world seems to be going crazy. As such, it is worth remembering to never underestimate the sheer power of the tail.

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