A Message to my Diamond-Handed Friends

The recent GameStop (GME) phenomena has been one of the biggest market stories of 2021. For full disclosure, I have traded GME in the past, both on the long and short side and have traded the volatility using GME options. As of the time of this writing I do not have any position in GME nor any GME derivatives. I will at some point in the future as the opportunity arises.

The recent speculative froth has brought to the surface a few observations that compelled me to opine. These observations revolve around the inherent perceived dangers that retail traders (the apes) pose to themselves and to the overall market. It struck me odd that, in a recent Business Insider article, the President of Goldman Sachs cited retail investors as one of the biggest threats to the bull market (Reeth, 2021). Sure, the Apes did a number on Melvin Capital resulting in a 49% loss in Q121 (Herbst-Bayliss, 2021), but I would be hard pressed to say that retail traders present a greater risk than say, funds like Archegos Capital Management that blew itself up and managed to take a few companies and banks to the mat through irresponsible use of leverage. I can certainly remember the 2008-09 “too big to fail” debacle and even further back, the Long Term Capital Management (LTCM) crisis that required a bailout from the New York Federal Reserve. In both instances, it seemed the economy would collapse without intervention. I do not recall an instance where a group of retail traders inflicted such potential harm to our market system.

I also believe the media coverage of the entire episode was more dangerous than any potential damage inflicted by retail traders. The entire ordeal was framed by the media coverage as a David vs. Goliath story, Main Street vs. Wall Street, the little guy raging against the machine. This may not be entirely accurate. Hasso et al., (2021) examined all trades executed at a retail brokerage firm from December 1, 2020 through February 12, 2021. In total, they gathered 65 million trades executed by over 700,000 retail investors. They found that buying GME was a favorite among these younger investors, but there were indeed substantial amounts of retail investors that took short positions in the name, indicating that retail investors were taking both sides of the trade. They state that the media portrayal of the battle between the retail investor and the establishment is too simplistic of an explanation of what really happened.

What about the notion that retail investors are a danger to themselves? The Financial Conduct Authority (FCA) out of the United Kingdom, aside from sounding way too totalitarian notes that higher risk investments may not be suitable for younger investors as 53% of those young investors surveyed claim that a significant investment loss would have a material impact on their lives (FCA, 2021). They claim that younger investors suffer from representativeness heuristics, overconfidence, and illusion of control biases, opening them up to greater susceptibility to poor investment decision-making.

Here is a news flash, we are all susceptible to cognitive and emotional biases, particularly as it relates to investing.

It is true that investors, young and old should take careful consideration when determining expected return and risk tolerance. Other consideration includes liquidity needs, your investment time horizon, and tax consequences. That said, I would argue that younger folks have greater leeway to assume a higher-than-average risk profile given their relative youth. Just do not be reckless – advice I’d just as quickly share with the folks at Archegos.

Contrary to the beliefs of many, I believe the rise of investment forums such as Reddit is a good thing. According to Graffeo (2021), one in five investors said they have used Reddit to drive an investment decision, according to a recent survey of 1302 respondents. The survey found that 80% of investors who use Reddit were driven to the platform by Wallstreetbets and 70% of those surveyed intend to use Reddit as a source of investment ideas in the coming year. This is viewed as a bad thing by many that argue such forums can be manipulative and a source of misinformation. While I agree with the statement, I would rebut with – what forum isn’t? TV (mass media), print, social networks are all subject to manipulation and misinformation. Perhaps my diamond-handed, ape friends are just too stupid to do anything but HODL. Well, I’ve got a few datapoints that would suggest otherwise.

Bradley et al., (2021) found that due diligence reports found on Reddit’s Wallstreetbets result in a two-day return of 1.1% on average after the research was posted. The returns drift higher up to 2% on average after one month and nearly 5% over the subsequent quarter. This is better than the highly coveted research found on Seeking Alpha and compares very closely to sell-side analyst recommendations, both of which are paid-for research. It should be noted that these returns were calculated prior to the GME phenomenon. This is in sharp contrast to the views that Reddit recommendations is harming retail investors and goes against the messaging sent by industry regulators.

Speaking of regulation, another observation has been the neo-capitalist views by regulators. Congress and the SEC have been investigating the Reddit movement to find sources of market manipulation. Macey (n.d.) is quick to point out the double standard. A large institution can build a short position in a security and then will write a research report discussing why the company is bad and why the stock price should fall. Additionally, many large fund managers then go on to cable news networks and use it as a platform to talk the stock price down. Many fund managers go as far as trying to convince industry regulators to open an investigation on the company whose stock they are short. Whereas with Reddit users, when discussing GME with the hopes of driving the stock higher, get called into Congress.

The rise of Robinhood and “free” trading is a wolf in sheep’s clothing in my opinion. Trying to project the image of the broker/dealer for the “little-guy” sells their order flow to the highest bidder so they can front run the order is clearly an ethical consideration, especially when the orders executed are not the best possible orders for the client (SEC, 2020). I recall when Interactive Brokers offered me the same deal – I said no way.

It really seems the array of financial institutions are working against the underdogs.

I for one am cheering for my rebel investor friends. I believe many good things can come from this experience, such as regulatory reform in the form of de-regulation. Also, this could spark a social movement to right the many wrongs that have arisen that make it difficult for the retail investor to get fair treatment.

The saying, “it’s not what you know but who you know” needs to be eradicated.

Joseph S. Kalinowski, CFA

Bradley, D., Hanousek, J., Jame, R., & Xiao, Z. (2021, March). Place your bets? The market consequences of investment advice on Reddit's Wallstreetbets.

FCA warns that younger investors are taking on big financial risks. FCA. (2021, March 23). https://www.fca.org.uk/news/press-releases/fca-warns-younger-investors-are-taking-big-financial-risks.

Graffeo, E. (2021, April 29). 1 in 5 investors in a recent survey said they've used Reddit to drive an investing decision - and the trend has grown since Wall Street Bets started the ongoing meme-stock frenzy. Business Insider. https://markets.businessinsider.com/news/stocks/reddit-retail-investor-trend-survey-social-media-wallstreetbets-wsb-stock-2021-4-1030366600?nr_email_referer=1&utm_source=sailthru&utm_medium=email&utm_content=opening_bell&utm_campaign=post+blast+moneygame%3A+10+things+you+need+to+know+before+the+opening+bell&utm_term=10+things+before+the+opening+bell+-+engaged%2C+active%2C+passive%2C+disengaged.

Hasso, T., Muller, D., Pelster, M., & Warkulat, S. (2021). Who participated in the GameStop frenzy? Evidence from brokerage accounts. Center for Tax and Accounting Research, 58.

Herbst-Bayliss Reuters, S. (2021, April 9). Hedge fund Melvin Capital lost 49% on its investments in Q1 -source. Nasdaq. https://www.nasdaq.com/articles/hedge-fund-melvin-capital-lost-49-on-its-investments-in-q1-source-2021-04-09-0.

Macey, J. R. (n.d.). Securities regulation and class warfare.

Reeth, M. (2021, April 27). Goldman Sachs' president believes the US economy will rebound stronger than expected in 2021 - but he's worried that 5 risks could still derail the market. Business Insider. https://www.businessinsider.com/goldman-sachs-president-market-outlook-5-risks-to-watch-waldron-2021-4?nr_email_referer=1&utm_source=Sailthru&utm_medium=email&utm_content=Business_Insider_select&pt=385758&ct=Sailthru_BI_Newsletters&mt=8&utm_campaign=Insider+Select+2021-04-28&utm_term=INSIDER+SELECT+-+ENGAGED%2C+ACTIVE%2C+PASSIVE%2C+DISENGAGED%2C+NEW.

Securities and Exchange Commission. (2020, December 17). https://www.sec.gov/news/press-release/2020-321.