An investor evaluating GameStop (GME) in 2020 would have found little to recommend it. The video-game seller was reporting losses due to pandemic challenges and changing consumer trends—gamers were increasingly buying their games online, not in brick-and-mortar stores. GameStop’s shares fell as low as $2.57 that April, and while they rebounded to end the year at $18.84, few people expected great things from the company in 2021. Yet less than one month into 2021, GameStop shares staged a stunning rally, surging as high as $483. Remarkably, that rally was not tethered to any substantial improvement in the company’s outlook—instead, it was the result of an investor-driven tactic called a “short squeeze.”
Short squeezes are rare and complicated, but the simplified version is that many investors were so pessimistic about GameStop’s future that they were shorting its shares—essentially betting against the company by borrowing the shares and then selling them at what they hoped would be a lower price. Investors who short stocks eventually must buy them back in order to return the shares they borrowed. A stock can be sold short simply because it is temporarily too expensive, as many hedge funds judged GameStop to be, or in rare cases when investors think the company’s success is an illusion, as was the case with Enron and Valeant.
Buying shares back normally isn’t a problem, but GameStop was so heavily shorted that other investors saw an opportunity—they aggressively bought the stock, driving up its price until the short sellers were forced to pay staggering amounts to repurchase shares, close out their short positions and limit their losses.
To some, the GameStop saga isn’t just a tale of fortunes won and lost…it’s a David-versus-Goliath story of small investors beating the pros. It was mainly Wall Street insiders who were shorting GameStop…and the short squeeze was led by an amateur investor posting messages on an online forum. For others, GameStop encourages searching for additional exotic and aggressive investment opportunities, such as cryptocurrency, rather than simply buying and holding stocks. But are these really the morals we should be drawing from this story?
Bottom Line Personal asked The Wall Street Journal editor Spencer Jakab, author of The Revolution That Wasn’t: GameStop, Reddit, and the Fleecing of Small Investors, what lessons investors should take away from GameStop…
That hot new investment opportunity you just heard about? You’ve probably already missed it. The star of the GameStop story is Keith Gill, a middle-class insurance company employee from Massachusetts who rallied fellow amateur investors to the GameStop short squeeze and who personally pocketed tens of millions of dollars in profits. But while Gill made his fortune, the majority of the small investors who tried to follow his lead lost money. Most became aware of the GameStop short squeeze only when the mainstream media trumpeted the story around January 26—and by then, it was too late. The stock peaked at $483 on January 28, and by February 2, it had tumbled to $90.
This pattern is repeated over and over in the investing world—an investment generates buzz for its incredible success…which attracts scores of new investors…who fare poorly because they missed out on the big early gains…yet the investment continues to be lionized because the early success makes its annual average return look impressive, even though most of its investors fared poorly.
Examples: Portfolio manager Cathie Wood rocketed to prominence when her Ark Innovation ETF (ARKK) returned 157% in 2020, but investors who piled into the fund because of that big year suffered through a 23.4% loss in 2021, then a further 30% in early 2022. A generation earlier, Peter Lynch became an investing legend by guiding the Fidelity Magellan Fund to average annual returns of 29% from 1977 through 1990, more than doubling the returns of the S&P 500—but many Magellan investors failed to beat the market because they missed Lynch’s impressive early gains. In fact, some estimates suggest that a significant percentage of Magellan investors actually lagged the market.
Keith Gill’s life-changing score gets the attention when GameStop is discussed…but investors would be better off reflecting on the losses incurred by GameStop’s many late-to-the-game losers when they’re tempted to take the plunge on future headline-grabbing investments.
It only seems like everyone online believes in that aggressive investment idea. In the old days, people heard stock tips on the golf course. These days, they’re more likely to find them online—the GameStop short squeeze gained traction on website Reddit’s “WallStreetBets” forum. Making investment decisions based on stock tips has never been a particularly prudent strategy no matter where those tips come from, but a quirk in the way online forums such as Reddit work mean that following tips found there can be especially dangerous.
Reason: Forums like Reddit give prominence to the posts that are most popular with its users…and the posts that attract little attention quickly disappear from view. Result: Posts advocating aggressive, shoot-for-the-moon investment ideas receive prominence, while sober “is-that-really-such-a-good-idea” cautions often are shuffled out of sight. The aggressive investment ideas aren’t popular among forum users because they’re the best ideas…they’re popular because it’s more compelling to read about aggressive investments and daydream about getting rich than it is to read schoolmarmish explanations of why these get-rich-quick schemes won’t work and/or conservative,
Gambling with stocks is not the same as investing. We tend to think of stock buyers as investors and casino goers as gamblers, but things aren’t always so clear cut. People who purchased GameStop shares in January 2021 were not investing in a company—few, if any, believed the retailer’s earnings or future prospects justified its skyrocketing stock price. They bought shares because they believed that the short sellers would have no choice but to pay even more for them later—this was more akin to sitting across from an opponent at a poker table than buying equity in a company. It is perhaps not a coincidence that the rush of young investors into the stock market in the spring of 2020 occurred when most sports leagues were shut down due to the pandemic, leaving would-be gamblers searching for action…and that the Robinhood stock-trading app that many GameStop stock buyers used looks a lot like a sports-gambling app.
Some people might wonder why it matters whether buying GameStop stock was an investment or a gamble. The difference: With an investment, it’s possible to compare the price being paid to the value of underlying assets or estimated future profits to gain some sense of whether you’re getting a good deal for your money. People who bought GameStop shares during the short squeeze could not realistically do that. This perceived opportunity was unrelated to the company’s actual value, so those who were evaluating the situation on January 27 or 28 couldn’t see that they had arrived too late—the fact that shares were already at $200, $300 or $400 didn’t mean that they wouldn’t climb higher still. Even investors who got in on the short squeeze earlier at lower share prices had no way of gauging the proper time to sell.
This should serve as a warning especially for cryptocurrency buyers, because it’s even harder to come to any meaningful conclusion about the true value of Bitcoin or Ethereum than it was with GameStop. Cryptocurrency has no underlying revenues—it’s worth only whatever people will pay. Helpful: If you believe that a trendy stock or cryptocurrency could increase dramatically in value, put only a small amount of your money into it—an amount so small that it won’t cause you any significant pain if its value instead falls to $0. If you’re right and this asset goes through the roof, then even your modest investment will deliver meaningful profit. Unfortunately, people who believe deeply in trendy stocks and cryptocurrencies often sink a big slice of their savings into them, putting their futures at risk.