Specifically, this questioner was focused on the recent craziness around Robinhood investors as it related to GameStop, hedge funds, short squeezes, etc. Once opinionated opinionists and commentators get hold of a meaty news bone like this, they proceed to devour it with endless speculation and regurgitation. That is not a pleasant thought, but if you are in the middle of the news blender, I think it sort of feels like that. Or, like the inmates are in charge of the institution, as I told our friend.
This was the gist of our response to the question:
Hedge funds are no different than any other managed fund except by their nature they take inordinate risks to return extraordinary returns…sometimes. They often borrow money to increase the investable assets, hence “leveraging” the investment.
They are prone to target certain companies they think will be very successful in the short term and/or “short” companies they feel are doomed to failure or decline. When they “short a stock”, they will borrow a share from someone who owns it and then sell it at the current price. Their hope is that the price will decline significantly, and they will then buy new shares to replace the ones they borrowed originally, and pocket the difference.
If instead, the price goes up instead of down, & the fund is forced to buy it at a higher price than the original share, they can sustain considerable losses. This is called a “short squeeze”. Sometimes the funds or “shorts” will try to assist the decline or accelerate it by spreading negative news releases or appear on talk shows to diss it. This is all legal and mostly ethical, technically at least. In the current scenario, GameStop is one of the most heavily shorted stocks on Wall Street.
All the current hoopla was just an effort to try to control panic buying/selling. The markets and brokers have a responsibility to “calm the markets” much like a bar owner has the responsibility to not sell too much alcohol in an attempt to reduce drunkenness. These steps are well delineated in the account opening documents.
Also, like in the current event, the institutions are required to have funds to back up the money that people are borrowing to buy on credit, or “margin”. So, when the crowd jumps up and want to buy a Billion $$ of XX (GameStop) on margin, the company has to produce the funds to do so. If they cannot or feel the risk is too great, they will cut off the trading to protect the company and the other investors. This is what happened with the Robin Hood brokerage; they ran out of money and quickly borrowed a Billion but even that was not enough, so they had to shut it down for a little bit.
Josh Brown’s blog (The Reformed Broker) title for yesterday was “Wall Street thanks you for your revolution”, with the observation that while some may think that all of this stock market action is the “little guy” getting their piece of the market, the bigger picture is that the Wall Street Big Dogs are still the ones benefitting and who will come out on top…again. You can read it here: https://thereformedbroker.com/2021/01/31/wall-street-thanks-you-for-your-revolution/
Adding to all of this temporary chaos, we are hearing about some underlying fear from several folks, stoked by who knows what sources, leading to another type of panic reaction to “sell everything”. This seems to be mostly driven by political fears combined with a good bit of anger directed at the “system” or a political party. While we are trying to encourage these investors to find balance and reduce their knee-jerk reactions as much as we are able, but it has reminded us of some of the words of the unflappable Warren Buffet. A google search brought up these two similar videos, but the timing is telling, because one is from 2017, and the other early in 2019:
To paraphrase, Buffet says that we should not allow politics to affect our investments. Maybe religion, but not politics.
He has also been known to make some rather astute observations that seem applicable to us at this time:
- “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd, or against the crowd.”
- “A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance.” (written in 2009 regarding the financial crisis)
- “In the 54 years (Charlie Munger and I) have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.”
This one might be my favorite for the context it provides:
“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Side note: and as of today’s close, the Dow is 30,211.91
So, we choose to defer to those who have been here before and try to walk in their footsteps, at least to the degree that makes sense for us. We don’t know everything, and every day is a chance to learn something new. But for now, perhaps the best advice is:
- Put down and disengage from all of your devices and take a deep breath or two
- Take a walk if it is nice outside, or
- Go watch some birds or perhaps some kids playing