The past couple of weeks have been interesting with respect to speculative trading activity in the stock market.
The activity of note centered on several small capitalization stocks, among them GameStop and AMC Entertainment, in which a group of retail “investors” communicating through social media bought these stocks together and drove the prices up dramatically.
The rise in the prices of these stocks forced certain investors, primarily hedge funds, who were shorting the stock (betting it would go down) to buy these stocks to avoid significant losses, thereby adding further to the upward move in price (this is known as a “short squeeze”). This short squeeze was fairly epic in nature and has caught the attention of both the regulators and members of Congress, who are looking into potential trading abuses or market manipulation. This activity appears to be isolated, technical in nature, and does not appear to be reflective of some greater problem for the stock market or underlying fundamentals.
There are a few things to note when putting this trading activity into perspective.
First, the activity is primarily technical in nature. While there may have been some rationale for believing the stocks were undervalued, the extreme gains in the stocks were most likely out of proportion to the stock fundamentals. Second, the activity was, in my opinion, speculative because a) it appeared to be a “mob” trading event and not based on fundamental analysis, and b) it appeared to be momentum driven which is a form of speculation. There is certainly no law against speculation, there are many forms of speculation and it occurs all the time. The problem with speculating is that it is highly risky and if abused or overdone has the potential to do great damage to one’s investment portfolio. For example, while GameStop stock rose by 800% in four trading days, it declined 89% in the following five trading days. Speculators who bought at or near the top experienced heavy losses.
As financial planners and fiduciaries, our role is to provide sound and prudent advice with respect to the management of client finances, including one’s investments, in order to maximize the probability of the client achieving his or her financial goals. As planners we would counsel against speculating with one’s money because it is an inherently high risk activity and greatly reduces the probability of achieving one’s expected rate of return on investments and, as a consequence, of achieving the goals of a financial plan.
There are a lot of methods to make money in the stock and securities markets. Not all of these methods are investing. True fundamentally-based long term investing in diversified portfolios has shown to deliver the highest probability of achieving an expected rate of return while minimizing risk. For this reason, I believe sound fundamentally-based investing is the best strategy for the vast majority people and can be accomplished simply and cheaply using low-cost index-based exchange traded funds.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.