Gambling vs. Investing

Slot machine at casino.

David versus Goliath

The financial media took a brief break from predicting everything that will happen in 2021 (don’t laugh; it’s their yearly habit) to bring us the engaging story of modern David versus Goliath.  The focus was on how masses of small amateur investors managed to bid the share prices of three largely unprofitable companies—GameStop, AMC Entertainment Holdings, and Blackberry—up nearly 1,000 percent, collectively.  GameStop alone rose more than 14,300%—surely, some kind of record for a firm with eroding market share and clinging to an outmoded business model. (The company sells video games through bricks-and-mortar retail outlets in a world where everything can be downloaded.)

The story was allegedly about David (the small investors) pitted against Goliath (several prominent multi-billion-dollar hedge funds), and the only reason you heard about it is because the small investors won and nearly put the hedge funds out of business.

Market Professionals

Market professionals recognize the story as a classic short squeeze: investors on one side (in this case the hedge funds) borrow the stock of companies they think are overpriced, expecting to buy them at a discount after the fall, allowing them to pocket a quick profit.  These short sales have an expiration date, so if the stocks unexpectedly rise in price, the short-sellers have to scramble buy the stock at the inflated price to limit their losses.  On the other side of the gaming table were a group of amateur investors who engage in online conversations and ganged up to raise each others’ bids.  When the hedge funds were forced to buy to close out their positions, the share prices went through the roof.  The hedge funds, meanwhile, lost an estimated $5 billion on their bets; roughly $1.6 billion on January 29, when GameStop’s stock jumped 51%. 

What the financial media neglected to mention is that this activity is not investing; it is, instead, a form of gambling.  The story tells us a great deal about the mindset of many retail investors these days.  When their goal is to make bets, and destroy other gamblers at the table, the game for everybody else becomes increasingly dangerous.  Take a look at the past 6 months of GameStop’s stock price and see if you can pinpoint when the gamblers started taking an interest.

Stock Market

Toward the end of every bull market cycle, there is an invisible line that is crossed. The public starts to think of the stock market, not as a way to share in the growth and profits of public enterprises, but as some kind of roulette wheel where the ball always seems to stop on a higher price.  These shareowners cease to be long-term investors. The prices are bid up not based on the underlying value of the companies, but on the expectation that whatever you buy, at whatever price, someone else will come along and pay a higher price.

Of course, markets only work that way for a short time, typically at or around market tops.  Eventually, the share prices of GameStop, AMC Entertainment Holdings and Blackberry—and perhaps many other stocks that are being gambled with at the moment—will return to something that more closely resembles the real value of the real company.  Long-term investors have tended to win the kitty over every past historical period.  Gamblers have seen their short-term winnings evaporate in the ensuing bear market.  The jubilant traders on subreddit r/wallstreetbets (does that name not suggest gambling?) can enjoy their winnings today. However, it may not be long before they’re counting their losses and wishing they hadn’t gambled away the money that could be used to buy shares when they finally go on sale.

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