Reddit, Robinhood and Market Timing

02/27/21 | Birchbrook Team | Birchpapers

The philosopher Rene Girard made a case for the existence of what he called “mimetic desire.” Essentially, he theorized that people are prone to want things not for their utility, but because other people want the object in question. Some people in a community start to want an object, causing others to think it must be worth having as well without considering the utility of the object independently. As more and more people end up wanting the same thing, this can lead to a snowball effect resulting in conflict. In order to end the conflict, the community must eventually choose a scapegoat on whom to blame the conflict, and this leads to eventual peace among the remaining members of the community.

We were reminded of this concept last month when users on a Reddit chat forum called WallStreetBets egged each other on to buy shares of heavily shorted stocks, most notably GameStop, with the intention of creating a short squeeze. This drove up the price of GameStop stock very quickly. Once the squeeze ended, however, the stock dropped back to earth.

A trader shorts a stock when he or she thinks the shares are overvalued and likely to fall in price. The trader borrows shares and sells them today with the hope that the price will decline in the future. Eventually, the borrowed shares must be returned to their rightful owner, which means the short seller must buy them back in the marketplace at a future, unknown price. The mechanics of a short sale are a bit like the following scenario:

Let’s assume you borrow a pound of sugar from your neighbor today in order to bake cookies, and you promise to replace the sugar next week when you go shopping. Your neighbor is very worried you may not return the sugar, so you give them a cup of flour as collateral. When you borrow the sugar, the price is $1.00 a pound. A week goes by, and you head over to the supermarket where you see that a pound of sugar now only costs $0.80. You buy the sugar at this price and return it to the neighbor. This means you were able to use $1.00 worth of sugar for one week, and you only ended up having to pay $0.80 for it, resulting in a “profit” of $0.20. If the price of sugar had increased, however, you would have lost money on the deal, because you could have bought it for $1.00 originally instead of borrowing it from your neighbor.

A price squeeze can happen with just about any type of good or service that is bought and sold in a market where demand exceeds supply. A short squeeze, by comparison, is largely a phenomenon of financial markets, because people don’t normally go around shorting things like sugar or cars. The dynamics are similar, however. In the stock market, a short squeeze can occur when lots of people have shorted a stock, and that stock moves up meaningfully in price. This increase in price might put multiple short sellers in a loss position and force them to buy back shares to cover, all at the same time. In our prior example, this would be as if half your neighborhood borrowed sugar from the other half, used it up, and then had to rush to the supermarket all at the same time to buy the sugar back. This sudden increase in demand for sugar would drive the price up and up. In the stock market, this type of extra buying puts significant upward pressure on the stock price, creating a ripple effect. It can force additional short sellers, who originally sold at higher and higher prices, to buy back their shares to avoid losses, driving the price higher still. In situations where a high percentage of a stock’s available shares are shorted, as with GameStop, this process can be magnified – because demand for shares significantly outstrips supply.

GameStop closed at a price of $18.84 per share on December 31st. Then, in January, users from WallStreetBets helped pushed the stock upward until, on January 28th, it reached a high of $483.00. Since then, the stock has fallen, reaching a low of $41.28 as of market close on February 21st.

Stock prices are volatile – a point we often try to make. But the extent of the volatility in GameStop was not driven by company-related news, such as a change in growth prospects. Some people in the WallStreetBets community bought the stock when it was relatively low and convinced others to buy it, leading the stock price to become detached from fundamentals. Getting back to Rene Girard, this created a conflict between the early buyers who were able to profit from the astronomical run-up in price and the later buyers who bought at higher prices. Many of these latecomers were convinced to buy based not on an examination of GameStop’s business prospects, but rather simply because other people had bought the stock and they expected other investors to keep buying it, raising the price even further. In the end, the people who bought at the height of the trade’s popularity were the ones hurt the most once the price plummeted. The trading app, Robinhood, which is widely used by Redditors, was essentially forced to halt trading in GameStop stock (and other Reddit-fueled stocks), which led to a steep decline in GameStop’s price. This made Robinhood a convenient scapegoat for people who lost money when the bubble finally popped.

While many of Robinhood’s practices have come under scrutiny for good reasons, the only way to avoid being burned by speculative crazes is to recognize them and not participate in the first place. It was clear in this case that the increasingly high stock price was not due to any company news or changes in business prospects. Rather, the price rose simply because the stock became popular to buy. After all, the stock market is a supply and demand market. It is true that some people made fortunes on GameStop because they happened to buy and sell at the right times. But those who bought at high prices after the frenzy took off were stuck holding the bag when the price dropped to a more realistic level. The challenge is that it is nearly impossible to know how long a stock will remain popular when this popularity is not tied to fundamentals. It is even harder to consistently and successfully trade based on popularity over time. Big gains might be made on some trades, but those gains will often be offset by losses on others.

A better approach is to buy individual stocks based not on what the crowd is doing but based on a stock’s underlying fundamentals. Diversification is also important. A particular stock should be viewed as just one component of your overall portfolio, with a specific role to play in furthering your financial goals. Holding a well-diversified portfolio can save you the headache of having to time the market, because, over any given time period, some stocks will do better than others. As circumstances change, yesterday’s leaders may become tomorrow’s laggards and vice versa. Picking good stocks is important, but diversification reduces the importance of precise timing.

Ultimately, successful investing comes down to managing our instincts. We tend to take cues from other people, so it is easy to think that if others are doing something it might be good for us as well. But with investing, it is important to not lose sight of the objective – attaining your financial goals. Saving money consistently, sticking to your investment strategy over time, and not getting sidetracked by frenzies or fads should keep you on a steady course to that end.