A Voice of Experience
Emerson Fersch, Capital Investment Advisers Founder, shared his long tenured perspective on the recent market events surrounding Gamestop, AMC Theaters etc. I thought you would appreciate his thoughts…
By now many of you are likely aware of the news regarding the trading of the common stock of GameStop, AMC, Bed Bath and Beyond, and Blackberry to name a few. Robinhood Financial has also been prominent in the news. There has been a lot of misinformation concerning this event with one late-night talk show host suggesting that the Russians were somehow involved, and with a chief strategist at Goldman Sachs declaring that this kind of trading activity has the potential “to create broader turmoil.” The reality is much simpler, less dramatic, and does not impact the long-term approach we employ to manage your portfolios.
In simple terms, what occurred last week is the reverse of the well-known buy low, sell high approach. Several hedge funds (large financial companies that make money taking huge risks) had placed trades called short sells, which means they sold stock with the hopes of buying the shares later at a lower price, effectively selling high and then buying low. This means they borrowed stock and sold it, with the idea that the price would go down and they would buy the stock later, thereby making a profit and close out the position. This is pure speculation, not investing. Typically, short selling occurs on the stock of companies or industries that are expected to suffer financially. Short sellers, often hedge funds, seek to profit from this.
Short selling carries significant risk, because whereas buying a stock at a particular price has a defined downside (i.e., if you bought a stock at $10.00, you know exactly how much is at risk- it can go to zero), selling short has an infinite loss potential (i.e., if you sold that same stock at $10 and it goes up, there is no limit to how far it can go up and therefore the loss potential is unlimited).
This is what happened with GameStop stock and others. Online traders, operating primarily through accounts held at Robinhood Financial, coordinated to buy the stock of these companies en masse driving the price of the stock up. Short positions of traded companies is public information, and by driving the price up these retail/online traders forced a decision upon hedge fund managers: either closeout the positions they had in these stocks to limit their losses (meaning buying the stock back at a higher price than what they sold it for and accepting a loss), or contribute capital to cover their margin (there are limits set by the SEC as to how much borrowing of securities an account can do—similar to how much equity a homeowner can borrow against a house) with the hope that by waiting longer, the price would eventually go back down. Either way, more capital is required, and the activity last week caught the hedge funds by surprise. Melvin Capital, which had significant short interest in GameStop, lost 53% in January and required a cash infusion from other firms to stay solvent. It is likely that there will be additional fallout and smaller firms will be forced to close.
This is an example of why some people see Wall Street and investing as gambling, and in my opinion, that is exactly what short selling and margin trading is. There is no plan and there are no goals except for making a quick profit with great risk. Therefore, I have always steered clear of this type of trading and quite frankly these kinds of account relationships. This reduces the process to a performance derby, which ultimately cannot be won. We build diversified portfolios spread out over different securities, different asset classes, different investment companies, different investment managers, and different investment products. This is precisely why last weeks’ GameStop trading and speculation does not directly affect my clients and their accounts. Our purpose is certainly wealth creation but guided by specific and quantifiable life goals rather than pure greed.
I appreciate all my clients and their trust in me. I have commented many times that having been in this business as long as I have, I’ve felt I have seen it all. 2020 was a reminder that I have not. Yet one premise holds true just as it has in the past: investing for the long term can be a sound wealth building strategy.
Sincerely,
Emerson Fersch
