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Gambling vs Investing: A GameStop Primer

Gambling or Investing: A GameStop Primer

*The goal for this blog is to provide a basic explanation of what happened and the important takeaways.  I will not dive into the nuances and try to avoid the technical aspects of what happened. 

What is GameStop

GameStop, you know, that store in the strip mall you or your kids visited to buy new and used video games 20+ years ago.  This was the time before games could be downloaded to a device in your home, or shopping at a brick-and-mortar store was considered lame.  If you were thinking, “wow, that place is still around”, you are not alone. 

The Background

Over the past 2 weeks, the financial media could not get enough of this story.  It replaced the typical 2021 market predictions, Covid, and the first 100 days of our new President.  The common theme was David (small investors) vs Goliath (hedge funds) and the idea that David was winning.  Essentially, what happened is called a “short squeeze”.

What Happened: Goliath

Investors on one side (the hedge funds) borrowed, or shorted shares of GameStop because they expected the share price to drop.  Then in the future, planned to buy shares at a lower price, return the shares to the lender, thus allowing the fund to profit on the price difference.  These short sales have an expiration date, so if the stock unexpectedly rises in price, the short-sellers (the hedge funds) must buy the stock at the higher price to limit their losses—more on this momentarily.

What Happened: David

On the other side of the table were a group of investors who engaged in online conversations like subreddit r/wallstreetbets.  These investors, noticed the high short exposure on GameStop and teamed up to raise the stock price, basically though buying shares.  They hoped and positioned themselves to ride the wave to profits as the hedge funds looked to limit their losses.

The Squeeze

When the hedge funds were forced to buy shares to close out their positions and return shares to their lender, GameStop stock price went through the roof.  Remember, the stock had a lot of short interest, therefore, as the demand for shares increased from the hedge funds, so did the stock price.  Basically, as the share price increased, Goliath lost more money and David made more money (at least on paper).  

A Teachable Moment

In this blog I used the term, investor out of respect for the participants on both sides of this trade.  However, I would not classify their actions as investing.  What we need to understand, this is a form of gambling.  Not that I think there was anything wrong about how this all transpired (at least the actions of those on the buy and sell side), but it is important to understand the difference. 

The stock market is a way to share in the growth and profits of public enterprises, (among other functions).  It should not be a roulette wheel.  When share owners cease to be long-term investors, and 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, we tend to have problems. 

Again, and to be clear, I’m not bashing the actions of David or Goliath in the above trades, they should be able to act as they see fit, but as someone tasked with trying to make sure my clients minimize the probability of doing irreparable damage to their finances, I must make a clear distinction between investing and gambling.

Of course, markets only work this way for a short time.  As you are seeing over the past few days, the share price of GameStop, and perhaps many other stocks that are being gambled with now—will return to something that more closely resembles the real value of the real company.

How many David-type investors escaped this trade with considerable winnings?  I’m not sure if we’ll ever know that answer, but I hope it’s a lot more than I think.  For the few who made life-changing profits, I hope they can back away from the table and know the difference between gambling and investing.  As we all know, most of the money that enters a casino stays with the house.