The GameStop saga that unfolded over the last few months is no financial fiction. The story has all the right elements to catch the attention of millions of people across the country, from the news media to everyman investors to people who’d never followed a stock market event in their lives: a David vs. Goliath drama with massive amounts of money in the mix. There was—and is—real money at stake: real money to be made, and real money to be lost.
When struggling retailer GameStop’s stock started skyrocketing at the beginning of the year, it was to the chagrin of Wall Street, which had bet against the company. But it was to the delight of many small-time individual investors, who bought low and sold high. Take for example, Mike McCaskill, a beach volleyball coach in Louisville, KY, with a side interest in playing the stock market, who was profiled by The Ringer in February. On the surface, McCaskill’s takeaway of $25 million (you read that right) on his GameStop stock sale sounds too good to be true, but McCaskill and the millions of other individual investors who made money on GameStop this winter could have also just as easily lost big—and some did.
What’s the moral to the story? The GameStop story illuminates some of the most important considerations when investing in the stock market: Within every investment there is inherent risk. And since the true amount of risk can never be guaranteed (the small type on any financial product will tell you that much), matching the investment to the investor requires a good understanding of risk tolerance and financial goals.
So What Happened With GameStop in Early 2021?
Like many traditional brick-and-mortar retailers whose business models have deteriorated in the digital era, GameStop, a chain store that sells video games and game consoles, was suffering as its customer base shifted to online games. To Wall Street, GameStop was looking old-fashioned. Hedge funds started betting that the company would tank; moreover, there was money to be made in the decline of the company’s stock. (Stocks are a type of security that represent fractional ownership of a company. When a company, such as GameStop, is publicly owned, its shares are traded on the stock market.)
The hedge funds’ position toward GameStop may seem counterintuitive for investors more accustomed to buying a stock because they believe in a company, and they think they’re going to watch it succeed and keep growing in worth. That’s known as a long position. But hedge funds, which are basically huge pools of investment money actively managed by Wall Street professionals—and generally limited to sophisticated, high-net-worth investors—were taking the opposite view. They were shorting the GameStop stock. In a short sell, an investor borrows a company’s stock, typically from a broker, assuming that its price will fall. The investor then sells the shares quickly on the market, then buys them back again when the price drops. After returning the borrowed shares to the broker, the investor recoups the price difference.
Yes, this is complicated and yes, this is a risky strategy. If the stock price rises instead of falls, the investor is on the hook to buy the stocks back at a higher price—and a stock price can always theoretically go higher.
In the case of GameStop, that’s exactly what happened, after individual investors jumped in the game. Unlike hedge funds that combine and manage millions—or billions—of dollars, individual investors are investing on their own, and in smaller quantities of stock. Investors following GameStop last winter noted Wall Street’s negative position toward it. In conversation on web forums such as Reddit’s Wall Street Bets, they talked about the potential in making the stock do exactly the opposite of what Wall Street had predicted. How? By buying the stock, thereby increasing demand—and the price.
Other investors, such as McCaskill, thought the company had more value than Wall Street was giving it credit for. McCaskill believed that GameStop’s fundamentals did not point to certain failure, which was what the hedge funds’ position suggested. He tipped off media influencers with a few well-poised questions about why Wall Street was taking such a negative stance on the company. (There was also the fact that RC Ventures, a venture capital firm, had made a noteworthy purchase of a large stake in the company last summer.) By buying GameStop stock en masse, all those individual investors drove the price up, and Wall Street was caught in what’s known as a short squeeze.
In a short squeeze, those investors who borrowed the stock, thinking its price will drop, are forced to return the shares to the lender, but now at a higher price. Instead of making the difference, they’re paying it. For the hedge funds, the loss on GameStop was massive. In the last week of January, the term “short squeeze” jumped in Google trends. Suddenly everyone was paying attention to the GameStop story.
Lesson 1: The Stock Market Is Complicated
What drew all that attention to the GameStop stock rally was the surprise factor; the expected wasn’t occurring. Instead, a lowly retailer was suddenly the most actively traded stock on Wall Street. But having expectations about the stock market’s behavior, although we do it all the time, doesn’t really make sense, because the market is so complicated.
The stock market is what is known as a complex adaptive system. In layman's terms, that means that the agents in the system—in this case, investors—can change their behaviors, which creates change in the system itself. Think about it this way: Every investor’s position is based on the position they think other investors are going to take. If we all think Apple will be successful, so we all buy Apple, Apple stock goes up, proving our prediction right.
Or—it doesn’t. Apple has to perform well, yes, but that is only part of the value of the company and the stock. When it comes to the stock market, both the predicted and the wildly unexpected happen every day.
Lesson 2: Investing Is All About Risk
The stock market is anything but certain, and that uncertainty equals risk. But risk is not limited to investing in stock. Every type of investment carries an element of risk. High-risk investing—like timing stock options—leaves you exposed to the downside, as well as the upside. But investing conservatively carries the risk that inflation might overtake your investments, and you won’t earn enough to keep up with the cost of living over time. (Similarly, putting your money under your mattress carries the risk that it will be worth less in the future, due to inflation.)
To balance out the risk inherent in investing, the common wisdom adheres to two basic investing strategies: asset allocation and diversification. Asset allocation helps protect you from the risk in a single type of investments—so your portfolio might include a mix of stocks, bonds, CDs or other types of investments. When you diversify, you choose many investments within an asset class—not investing all your stock spend, for example, on one company’s stock, but choosing several. Your asset mix and diversification strategy depend on your risk tolerance.
Lesson 3: Every Investor Has Their Own Risk Tolerance
Remember McCaskill, the man with the $25 million payday from selling GameStop stock? There’s more to his story than his get-rich-quick moment. In fact, McCaskill had been playing the stock market for years—and his results were up and down before he hit it big. By anyone’s estimation, he would be considered an investor with a high risk tolerance. Risk tolerance is the ability of an investor to accept potential losses while waiting for an investment to increase in value. And it’s as individual as your own psychology. At times in the past, McCaskill would be up to nearly six figures in his brokerage account, only to lose it all.
Can you take that kind of hit and still sleep at night? Your own personal risk tolerance is crucial in determining the type of investments that make sense for you. Do you value stability? Can you pay your bills if an investment loses thousands? Are you putting your financial goals at risk? All of those questions play into your risk tolerance and should inform your investment choices.
Lesson 4: Short Cuts Are Riskier Than Long-Term Planning
The appeal of the GameStop story was, in part, the seemingly overnight wealth accrued by investors who rode the stock to a high and sold to make a profit. But again, keep McCaskill in mind. He was willing to calculate probabilities and willing to take the risk to time the market—which is what investing in options is all about.
Many investors don’t have the time to be that involved in their investments on a daily basis, or the tolerance to handle that type of uncertainty. Short cuts are high risk, and your risk tolerance may not be compatible with that type of investing, where losses could be bigger than gains.
Long-term planning, on the other hand, takes market swings into account, allowing for your portfolio to recoup short-term losses over time. That’s why many financial planners recommend setting a long-term strategy—including your asset allocation and diversification—that will help you achieve your goals, checking in on it at set intervals and not sweating it (too much) in the meantime.
Lesson 5: Social Media Isn’t a Financial Professional
Just weeks after the combined action of individual investors sent GameStop shares soaring up 865%, the stock took a significant tumble after the company’s quarterly earnings call, which didn’t impress investors. Was this the end of the fairy tale? Was it a course correction? Time will tell, as the stock has proved to be up and down through all of March. But for every investor who jumped on the GameStop bandwagon and made money, there are likely many others who timed the transaction wrong and lost out. Following the herd can hurt.
On the other hand, the GameStop story does remind us all of the importance of the individual in making their own investment decisions. Whether you’re choosing a targeted retirement fund, playing the market, buying options or sticking with more conservative choices, whether you work with a financial advisor or do your own homework, they should be your choices. Your investments—and financial future—are too valuable to be left up to anyone else.
Julie Anne Russell is a Brooklyn-based freelance journalist. She writes on personal finance, small business, travel and more.
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