When Robinhood takes money from the not-so-rich

By now you’ve probably heard all about social media putting one over on the big hedge funds by purposefully jacking up the stock price of companies like GameStop.

The members of an internet-based Reddit group (known as a subreddit on the popular social media site) decided to act in concert and use the free-to-trade stock app Robinhood, to buy up shares of struggling companies like game retailer GameStop and movie theater chain AMC. One of the stated reasons for taking this action was to punishing large hedge funds which held significant short positions in these stocks.

In a nutshell, short sellers are betting that a stock’s price will decline. Basically, they hold a position as though they had sold shares at a certain price. For the trade to be profitable, they must close their position by buying shares below the price where they are “short” the stock. To do so, they must borrow and “pay rent” on the stock to hold their short position, incurring costs over time. Of course, if the short sellers bet wrong, they can lose significant money if the stock price goes up.

With both movies and video games going to online distribution, it seemed a sure bet that businesses that distribute these via physical locations would see their market share decline. Unless thousands and thousands of Redditors collectively decide to buy their stock in a short period of time.

The press has hailed this as the democratization of Wall Street. Previously, small investors have not had the ability to affect prices. But according to CBS News, despite this moment of crowd power, many small investors have sustained huge losses as the pumped-up stocks quickly plummeted in price.1

But even if an investor is successful at picking winning stocks some of the time, active trading works against him in the long-term.

According to Dr. Shlomo Benartzi, co-head of the behavioral decision-making group at UCLA Anderson School of Management, research has shown that this kind of strategy increases risk.2

He writes that although active investors are trying to minimize volatility by market timing (dumping losers and trying to pick winners), they end up doing the exact opposite. According to the research, “the volatility of the actual investor experience is nearly 50% higher than the corresponding volatility of stock returns.”

In other words, even if there were no transaction costs, you’re statistically still better off buying and holding.

Of course, the prudent investor would avoid assuming the highly speculative risk of concentrating long-term capital in a few individual stocks. Disciplined investing requires staying committed to a broadly diverse portfolio that’s engineered to meet your risk profile and time horizon. Yes, that’s true even when the news headlines are touting 10x gains in an individual stock.

Anecdotal evidence about a skyrocketing stock is usually about as meaningful as last week’s lottery numbers. They’re not hard to identify in the rearview mirror. Your trusted advisor can help you understand your long-term strategy and stay disciplined when “the crowd” is chasing short-term winners.

View the article here. 

1. http://go.pardot.com/e/91522/-losses-reddit-2021-02-03--app/6vqq9q/1102999599?h=J16ZunxE3Z-xh6hm8TEEfJZ4setTKbMTmYI1ZxgTVZM
2. http://go.pardot.com/e/91522/TheWallStreetJournal-goTo-R007/6vqq9s/1102999599?h=J16ZunxE3Z-xh6hm8TEEfJZ4setTKbMTmYI1ZxgTVZM

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