There have been opinions galore on the most fascinating financial news of the week (and possibly far longer): the Gamestop/Reddit investing drama. Pundits and commentators from all sides of the political spectrum have been weighing in on the saga all week, but I have not yet seen any of these accounts which perfectly captures my feelings on the issue. First off, I’ll do my best to quickly explain what actually happened before diving into my thoughts.
This past week saw the first of likely many battles between hedge funds and the individual Internet day traders who organized into a formidable pseudo-cartel on social media platforms like Reddit and Discord. This initial foray centered on the stocks of publicly traded companies including the video game retailer Gamestop, the telecommunications company BlackBerry, and the movie theater chain AMC. Hedge funds including Melvin Capital had targeted those stocks and others like them as prime candidates for short selling — a process in which an investor borrows a share of a company for a period of time and promises to return it with interest. They then proceed to sell that stock, betting that it will decline in price over the agreed-upon period, before buying it back at a (hopefully) lower price and pocketing the difference. This is an extremely common practice among large-scale investors and helps to properly determine market pricing of shares, driving down the price of stock in companies that are overvalued. The Reddit investors on r/WallStreetBets, a forum dedicated to day trading and risky investing maneuvers for individuals, saw the massive short positions these hedge funds took in Gamestop, among others, and decided to work together to short squeeze the funds in an attempt to make a large profit as well as force the funds into massive losses. They did this by buying up as many shares of Gamestop as possible, driving up the price and forcing the short selling hedge funds into taking large losses on their now-bad bets. Of course, a retail video game store isn’t actually worth as much as Delta Airlines (as Gamestop briefly was earlier this week), so the price will end up declining over time, leaving someone holding the bag; that will likely end up being the individual investors who risked a lot participating in the Reddit tactic, not the hedge funds which are well-equipped to handle losses even as large as this.
Now that I’ve explained a bit about what happened (for more, check out the coverage of this saga in any of the major financial news outlets, from CNBC to the Wall Street Journal), I would like to say a bit about how I feel about it and what I think the response should be. I’m what one would call a laissez-faire capitalist; that is, I believe in the power of the free market to properly set prices, generate prosperity, and create stable industries and jobs. I believe that government regulation of markets does more harm than good in the vast majority of cases and prefer to see the immense information-synthesizing power of the market used to drive the economy versus a more centralized, top-down government approach. In this respect, I’m far more in the camp of American as opposed to European capitalism, at least in the modern sense of those terms (I see myself as a classical liberal in the mold of the great 17th century British theorists Adam Smith and David Ricardo or the 20th century American economist Milton Friedman). As a laissez-faire capitalist, I think this whole Reddit/Gamestop saga is great. It showcases the true democratizing force of the free market, allowing people with fewer resources to pool together and compete with globe-spanning hedge funds with billions of dollars under management. It is reckless, as are many investing gambits, but risk is a crucial part of life, both financial and otherwise. Allowing people to make their own risk-management decisions fits well with an ethos of liberty and individual agency. But what of the loss potential and the incentive structure around these trades? Won’t this keep going into the future, destabilizing markets all the way? Probably not, as nothing sets one onto the path of basic investing (ETFs, index funds, etc.) like a speculative loss. People tend to learn from their mistakes; but to learn from mistakes one must be allowed to make them and feel the consequences of those errors.
That goes the same for the hedge funds impacted by the short squeeze. I have read market commentators and investors seeking to bail out these funds for the losses incurred, as well as bully social networks and investing platforms into banning these smaller users and their communities. I’ll deal with each of these terrible ideas one at a time. First, there should absolutely be no bailout whatsoever for these hedge funds. If they can’t properly protect themselves from the downside risk of a perilous investing strategy like the one they made in Gamestop, they deserve to go belly-up. In fact, the losses incurred by these funds are all a part of the market mechanism I described so lovingly above. The market tends to price in all information about a stock or a strategy; this — the coordinated short squeeze by online retail investors — is new information and part of the pricing-in process involves those who were overleveraged (the hedge funds) taking their due losses. Removing the market mechanism here and replacing it with a government edict that these funds cannot be allowed to go bankrupt will only lead to a fundamentally mispriced market replete with distortions. That’s to say nothing of the social impact of bailouts here; the, in my opinion, necessary bailouts of the 2008-09 crisis caused a great deal of social unrest, starting with Occupy Wall Street and possibly culminating in the election of Donald Trump to our nation’s highest office. A bailout now, in the middle of a pandemic and the concomitant economic crisis, would be several times worse, even if it was comparably small in dollar terms. With respect to banning the communities in which these short squeeze strategies were hatched, that is another awful idea. Not only would it continue a process of the diminution of free speech online, it would be bad policy. As I’ve said in other pieces, we live in an era of instantaneous Internet communications; that toothpaste cannot be put back in the tube. The discussions on Reddit and Discord were largely public in nature and did not involve criminal activity (as far as we know as of this writing). If large-scale investors can be caught out flat-footed by these sorts of discussions, they would certainly have no chance when the communities move to more secure, private, encrypted messaging platforms.
Altogether, this entire saga shows the power of the free market as a leveling and democratizing process, helps improve the long-term resilience of the stock market and investing through the incorporation of new information, and honestly is quite funny. In an era when free-market capitalists like myself have very little on which we agree with the “Eat the Rich” socialists, this is a welcome respite. Even if we can only agree on the humorous aspects of this entire saga, it’s more than I could say about most things. And given the tumult and rancor of the past year, I think we all need some of that.