Last month, the price of previously unloved GameStop stock surged more than 400% in two trading days as a small but spirited community of retail traders rallied against Wall Street’s mighty hedge funds.
Using Reddit’s community chat forum to swap trading tips, small investors used online trading platform Robinhood to buy GameStop shares quickly and cheaply. This coordinated buying pushed GameStop’s price higher, forcing short sellers—those betting on GameStop’s demise—to buy more shares, further accelerating the run.
Enthusiasm for GameStop eventually waned as traders sought to cash in on the get-rich-quick scheme by unloading shares. While the GameStop roller coaster is likely not over, shares are trading today about 70% below their peak price of just a few weeks ago.
What can we learn from GameStop?
Lesson #1: Chase the Herd, and You May Get Trampled
A captivating rise and fall in a stock’s price is nothing new. But it all may have seemed bright and shiny to a collection of bored, homebound retail investors dabbling in, and learning about, markets for the first time via the chat-o-sphere.
These recent events display all the same signs of past, similar stampedes. Whether manias we’ve read about in textbooks (tulips in the 1600s or railroad stocks in the 1800s) or asset bubbles we’ve witnessed firsthand (tech stocks in the late ‘90s and real estate in the mid-2000s), this story has played out before.
Below is an excerpt from our newsletter to clients in 2005. Replace “real estate” with “GameStop,” and “cocktail parties” with “Reddit,” and the message is the same:
The telltale warning signs are mounting. First, consider the simple fact everyone is talking about real estate. It is the hot topic at cocktail parties, on cable TV shows and in newspaper articles, and has graced magazine covers. It is almost hard to hear yourself think over the din of real estate chatter.… Believing the game has only winners, more and more “investors” jump on the bandwagon.
Sure, a small percentage of folks got lucky and rich on GameStop. But as increasing numbers of buyers were needed to sustain and further fuel GameStop’s price rise, the grim reality is a far larger number were skewered by its eventual crash.
Sadly, do-it-yourself traders have been hammered by herd mentality for hundreds of years. But never before has it been easier to get swept up into it via trading platforms, such as Robinhood, that mimic a gambling casino—complete with confetti, emojis, and similar celebratory “rewards” for every trade placed.
Capital markets can be mighty unforgiving to those who ignore history and instead chase the herd.
Lesson #2: Price Matters. Yes, Really.
Whether it’s real estate in 2005 or GameStop in 2021, a critical constant reminds us why chasing a herd can so readily send you off a cliff: Price matters.
Specifically, high current prices imply lower future expected returns. Low current prices imply higher future returns.
This is no guess, it’s basic math. That, and about 100 years of real market data tells us a stock’s current price (p) should equal its future dividend (D), divided by a discount rate (r):
p = D/r
That final variable, (r), represents the riskiness of a company’s dividend (or, cash flow or earnings). Importantly, it also represents an investor’s expected return. Consider:
- If the dividend (D) increases, with no change to investors’ assessment of the riskiness (r) of that dividend, then current price (p) should go up. In other words, the stock’s prospects are more attractive, so investors willingly pay more for it.
- If the dividend (D) stays the same while the discount rate (r) rises, current price (p) should fall. The stock appears riskier, so investors rationally demand more compensation for holding it.
In the case of GameStop, prices went up. Way, way up. And yet, (D) stayed the same, as nothing changed with the company’s fundamental business or prospects.
What else changed? The discount rate, (r). For the above equation to balance, it had to go down—along with investors’ expected returns.
Let us repeat: expected future returns don’t go up when prices surge; they go down.
So, the next time anyone tells you to buy “at any price” lest you miss out on the ride, run fast—in the opposite direction.
Lesson #3: Diversification Is All The Company You Need
So far, we’ve emphasized what NOT to do with your investments. Don’t chase the herd. Don’t buy at any price. But what is there TO DO?
Diversify, plain and simple.
By spreading positions across thousands of businesses spanning geographies and industries, sizes (small and large cap) and styles (value and growth), stock investors “piggyback on capitalism” around the globe. That has been the surest way to earn an appropriate measure of stock market returns over history. That’s the power of diversification.
Sure, a diversified portfolio may never rain confetti on those who check its daily activity (you shouldn’t). But neither is it ever likely to deliver a devastating sucker punch to your greater financial goals.
By the way, if you haven’t been tuned in to the GameStop show, that may be the best evidence you’re appropriately diversified. The index and asset class mutual funds Vista favors in client portfolios—specifically those that owned GameStop during this feverish period—barely budged in response. GameStop mania was literally a “nothing to see here” event in a portfolio holding thousands of stocks.
That’s all the company we think you need.
The Successes Worth Celebrating
At Vista, we take delight in celebrating our clients’ successes right along with them.
But that usually involves giving them a high five when clients retire as planned, fund a vacation home or reach a new portfolio milestone—not sending confetti and emojis to validate short-term trading.
From experience, we know goals reached through a combination of time and discipline are the ones worth pursuing—and honoring.
