I wrote an article on GameStop, and my view of the whole saga a week ago. I think it's one of my more "controversial" articles, the reactions to it at least seem to indicate so. One of the reactions was from Wim Steemers, a fellow behavioural scientist with a background in finance, and a friend. He utterly disagreed with my writing and asked to plead his case. That is what you'll read in this article: a rebuttal from a behavioural financier, Wim Steemers.
The story of what happened with the GameStop stock has so many angles to it that it is useful to present some of these angles in different sections. Apologies in advance for the amount of background information given, but I think it’s crucial to have this background in order to understand what is really going on.
The Philosophical Angle
What is the function of stock markets? Why do we have them? Is it a way for rich people to make ever more money, as the Redditors seem to think? Stock markets came into existence in the 16th and 17th century as several companies started to find they needed more capital to finance their growth plans than they had available. The solution was to raise money from people not associated with the owners of the company (for example, the founding family), and in return to give them an ownership stake in the company. The Dutch East India Company (in Dutch: Vereenigde Oostindische Compagnie or VOC) was the first one to do so. The function of providing capital to companies that need more capital than they have available themselves is still the primary goal of stock markets today.
As stock markets have grown and evolved over time, and economies have grown and become more complex, stock markets have become the best way yet devised to allocate capital to its most productive use. Let’s pause for a moment here – what does this sentence mean? Say a society has a dollar of capital that needs to be allocated to some activity. If your goal is to create the best outcome for society, how is this best done? Broadly speaking, there are two ways of doing this. The first way involves handing over the capital to a group of bureaucrats (for argument’s sake, let’s call them Apparatchiks), and ask them to decide. They will decide they’ll use some to build a tractor factory, some to open a series of shoe shops, etc., etc. The second way involves leaving the capital in the hands of countless individuals, who all try to find the investment opportunity that gives them the best return. Experience shows that the first way (think Soviet Union) leads to shoddy products, empty shelves in shops, poverty, waste, environmental degradation. The second way leads to growth, innovation, abundance, and a better environment. Comparing the state of the Soviet Union at the end of its existence (1990) with the state of the economies in the West should really leave no doubt about this point. And for those who believe the West’s model of economic growth is destroying the world, let me say this: you may be right, and it’s a debate worth having – but there is no question that the central planning way of doing things is far, far worse. The West gave us so much pollution that rivers caught fire, but then cleaned it up. The Soviet Union destroyed the Aral Sea and never did anything about it.
This isn’t to say that the second way doesn’t have any problems. To paraphrase Churchill: it’s the worst way to do things, except for all the others (and we’ll come to some of the problems shortly). However, the broad economic truth is that efficiency/productivity is the only way to improve living standards. And before you accuse capitalism of destroying the environment, just think about this: if I need a house, or a car, or a TV, and it can be built in two ways – one of which uses half the iron ore, half the cement, half the plastic, half the energy than the other, which way of production is better for the environment?
Now, here is the magic: if individual investors are all trying to invest their (or more commonly, their clients’) money in those opportunities where they expect the largest return, what will happen is that capital will flow to those companies that have figured out a way to make more with less. This is the Invisible Hand that Adam Smith talked about. This is not greed gone mad, this is of benefit to society.
What does this have to do with GameStop? The point I’m trying to make is that, if well-functioning stock markets are beneficial for society, then by extension, disruption of the kind we saw with GameStop, where the stock price of a company went to levels that clearly did not reflect the true value of the company, is bad for society. It was a massive misallocation of resources. Waste is bad for all of us, period.
Is shorting bad? Does it involve things like “Melvin Capital wanted to it see it fail just for the sake of making profit, as they had shorted the stock.”, as Merle writes? Merle clearly explained the mechanics of shorting. But what is the function of shorting in the stock market in general? As discussed above, the stock market is the most efficient mechanism we have to decide at a macro level where capital is best allocated. The way this works is that many investors make their best guesses about what each company on the stock market is worth, and then proceed to buy the shares of those they think are worth more than the current price, and sell those they think are worth less. This buying pushes the share price up, and the selling pushes it down – thus causing the price to move to the real underlying value. Note that individual investors can be right or wrong (and thus make or lose money). The point is that the market aggregates all these individual points of view [e.g. “The Wisdom of Crowds” by James Surowiecki], and thus ensures capital ends up being allocated where it is most productive. In this context, the practice of shorting adds a useful perspective to the market forces, and thus will move the share price to its ‘true’ value quicker than it otherwise would. This not only benefits society through a better allocation of capital, but it also protects investors against losses they might otherwise endure. Note that if the shorter is wrong about his expectations for the future of the company, he will lose money. But if he is right, sure, he makes money, but importantly in the process he will also have accelerated the stock price reaching its fair value, and thus saved other investors from losing money for the period that the stock price would otherwise have been trading above its true value.
Where the stock market goes wrong
As mentioned above, the stock market doesn’t always get it right. As long as stock markets have existed, people have tried to manipulate them for their own benefit – indeed questions about governance existed for the VOC itself. Things like insider trading and share price manipulation are serious problems, and for this reason stock markets are among the most heavily regulated entities in our economies. For example, it is illegal for Goldman Sachs, Morgan Stanley, and JPMorgan to get together and agree to push a certain stock story to all their clients, in an effort to create buying pressure and thus move the price up (do you see the parallel with Reddit coming?). It is illegal to buy are sell a stock if you know something about the company that others don’t know. Seriously! People do go to jail for this. What’s remarkable about this, is that these crimes often are experienced as ‘victimless’. So I buy a stock today because I know the company will publish some good numbers tomorrow. The stock goes up, and I make a profit. Who did I hurt or steal money from? The answer is that a whole lot of people made a bit less money than they otherwise would, but you can’t really specify which people and how much. That the criminal justice system allows for criminal penalties even though the victims are not identifiable (the only crime I know for which this is true) shows how seriously regulated stock markets are. What about regulation related to shorting? Merle mentions:
This tactic of shorting is often also helped that at the time the stock had been shorted, a report regarding the company would come out, which was critical or just down right destructive, as a result further decreasing the demand for the stock, and as such plummeting its share price. It doesn’t take a genius to figure out that these tactics are in the grey area of being legal (they are though). And from a moral standpoint: disgusting.
If the report that a shorter puts out is not made in good faith, she is completely right. This behaviour constitutes market manipulation: disseminating (false) information into the market with the aim of influencing the market price. Shorters who engage in this sort of activity break the law and deserve to go to jail – but note that the crime is market manipulation, not shorting. If the report is made in good faith, the shorter is doing the market a favour. If he is right, investors are protected from making losses they otherwise would have suffered. If he is wrong (and he very well might be), he will lose money. Let’s not forget that the fact that a shorter puts a report out doesn’t mean investors are obliged to sell the stock – they still have to make up their own mind.
Democratization of investing – a good idea?
It is said the that the GameStop events show that democratization of investing has arrived. Thanks to apps like Robinhood, finally the small guy has a chance to invest like the one-percenters always could. The playing field is evened out! On the face of it, this seems a good thing. Isn’t it unfair that the rich can invest how and when they want, while common man can’t?
Let me paint a hypothetical picture in a slightly different realm, and ask you how you feel about that (with the caveat that no comparison is perfect):
For as long as anybody can remember, doctors have decided what treatment to apply to what disease. How patently unfair! The common man is kept out of this lucrative activity! An app has now appeared that lets the common man do what all these doctors have done for so long: make diagnosis and decide on treatment. In fact, let’s stick it to those doctors! Let’s all decide that chemotherapy for cancer is wrong! All cancer patients, please join this Reddit group and commit to this herbal tea treatment for cancer that I developed! That’ll teach those doctors. Yolo[vi]!
Ridiculous! For sure! But why? We (most of us anyway) instinctively understand that the many years a doctor spent studying makes him more qualified than ourselves to diagnose and treat disease. Why is it any different for investing? The big misunderstanding is that people draw a distinction between rich and poor investors (which would be unfair), whereas the proper distinction is between properly trained and untrained (which is analogous to the doctor-patient example). Most professional investors have regular jobs – well-paying for sure – but most are not billionaires. They work hard to achieve the best outcome for the people with whose savings they have been entrusted: pension funds, endowments, etc. Democratization of investing is a lofty goal, but democratization without education and training is dangerous – both for the individuals themselves and for society at large.
But here is another question: was this really democratization of investing at work? Or can we compare the collective behaviour of WSB (WallStreetBets, the sub-Reddit on which the GameStop story unfolded) to the collusion of for Goldman Sachs, Morgan Stanley, and JPMorgan mentioned earlier? Of course, there are those who will argue that yes, you can compare those behaviours, and in fact that is exactly the point: the small guys doing the same unfair thing that Wall Street has always been doing. My response to that would be: leaving aside that such gross collusion between large investors rarely happens (it’s just too risky), you don’t right a wrong by imitating it!
Who got hurt?
At this point many readers will probably feel all of the above is just so much self-serving dribble, typical of exactly the problem that the Redditors are trying to attack. So let’s move to the final and perhaps most relevant point: who got hurt in this sorry episode? First, a quick abbreviated timeline of the facts: Redditor DeepFuckingValue bought some GameStop stock and started to hype the stock on WSB; the stock started to go up; more and more people got in on the action as the stock climbed from $5 to $500 – many proclaiming proudly that they would never, ever sell; on the day that Melvin capital needed to be bailed out, many other stocks that were heavily shorted rose in value, while almost every other stock fell in value (this was the result of a very broad movement of risk-reduction across investors who suddenly faced a lot more uncertainty about future stock prices than they had up until that point); a few days later the stock price of GameStop started to fall, and it has been falling ever since.
So who won and who lost here? The winners are:
People who owned the stock before all this started, and sold as the craziness started. They got lucky.
Redditors who got in when the stock started to go up, and sold at a profit within the first 1-2 weeks. They were smart, albeit that they were not true to the diamond-hands-creed of the group!
And who lost?
Melvin Capital. Who cares? Professional investing comes with wins, losses, risks. No tears need to be shed over this.
Redditors who got in a bit later, were sucked in by all the hype and held on after the peak. They stuck it the hedge funds (good job guys!) but may have lost their life savings.
The following conversation between a father and his young child 15 years from now is easily imaginable:
Daddy, tell me again how you got this job stacking shelves at Walmart? Well son, 15 years ago I was in university studying to be an engineer, when I had this opportunity to join the movement to stand up against Wall Street. I took all my savings, maxed out my credit card, drew down all my student loans, and put it all in this stock called GameStop. It was fantastic! We drove a hedge fund out of business! I never sold! The company went bankrupt anyway, so I lost all my money. At that point I had all this debt, but no money in the bank, so I couldn’t buy any food or pay my rent, and I had to drop out of university. I got this great job stacking shelves at Walmart, and I’m still paying off that debt. But hey, diamond hands, it was all worth it!
If you think this is far-fetched, you haven’t gone on WSB – the site is full of people proudly announcing they have put everything they have in this! Yolo! At least the Redditors in the previous bullet point did it to themselves. Not so the millions of people who entrusted their money to pension funds, regular fund managers, insurance companies, or own some stock funds directly. These people have seen their hard-earned savings decline. Was this part of the plan, my dear Redditors? Was your desire to stick it to Wall Street so great that you were willing to hurt your grandparents? Or had you just not thought about this? I didn’t think so…
Merle writes “this was not really about money” – which is indeed a phrase that popped up frequently on WSB. Really? Perhaps this is true for some of the Redditors, but there are two reasons to think that for many it might not be. First, there were plenty of posts on WSB that talked about how the poster (or “retard” as they call themselves) was about to be able to pay down their mother’s mortgage, or buy a new car, etc. Second, I daresay it might feel different to say “it’s not about the money” when the balance on your Robinhood screen has just quadrupled, then when that same balance has shrunk to pennies! More importantly, however, it would certainly be about the money for the pensioners who now cannot take that trip to see their grandchildren they were planning to take…
The role of Robinhood
The role of Robinhood in all of this is frequently misunderstood. The first thing to note is that, as the adage goes, “if you are not paying for the product, you are the product”. Robinhood makes its money from selling the orders that its customers place to “market makers” – which are middlemen between buyers and sellers on the stock market. Nothing necessarily nefarious about this, but there is an irony here that the Redditors in their exuberance about “sticking it to Wall Street” have (unwittingly I believe) channelled large amounts of money to some of the essential providers of the ‘plumbing’ of the stock market – as essentially Wall Street as you can get!
The second thing is around the supposed motivation of Robinhood to stop new buys in GameStop and a few other stocks. It was immediately assumed that they had been pushed by the hedge funds under attack to do this in order to stop the price rising further. The truth, however, is much less prosaic. When you buy or sell a stock, you will immediately be informed that you own/no longer own the stock – but there is a lot of work that needs to happen behind the scenes for ownership to actually be transferred. This back-office work takes a couple of days – in the jargon: “settlement takes place on the second business day after the trade”. To streamline things, and to make sure all trades are indeed settled, this settlement takes place through a central “clearing house”. The clearing house requires that all participants (ie. brokers) keep a certain amount of money in reserve (“collateral”) to cover potential cases of a buyer not being able to actually pay, or a seller not actually having owned the stock he said he was selling. This is normal practice, and good for everybody (imagine how you would feel if you just bought a stock and were told two days later “sorry, it didn’t work out, you don’t own this stock”?). When the share price of GameStop started to go up, the risks of non-settlement increased, and the clearing house required more collateral from Robinhood (again, this was normal and happens all the time). The magnitude of the increase (rocket emoji, rocket emoji!) was such that Robinhood simply didn’t have the money. They proceeded to raise over $3 billion (!) from their owners in 2 days, and trading resumed. Rather than scolding Robinhood for restricting trading, they and their owners should be commended for the commitment to their customers in fronting this capital!
Let me be clear, I am no fan of Robinhood. I think the gamification of investing (if you can call it that) is bad for its customers and bad for society. But the restricting of buying GameStop was not “The rich old suits whined to the right people, and “sanctions” followed, as seen with Robinhood’s restrictions”, or “The platform turned against its younger users, showing just how much it cares about them, and about the systems holding it in place.”
Merle writes: “What we’ve seen here is that there is lots of anger against the wealth and power division in society, and although we can claim that, thanks to the internet, there is a larger platform for democratization, this is not happening.” On this point she and I agree. This anger in society is something that needs to be addressed. Luckily, more and more people are waking up to this, including many economists, who are studying inequality as a factor in economic growth and development. However, what the Redditors have done does not in any way address this problem at all. They have hurt the economy, society, themselves, and countless hard-working people who had done nothing more than work hard, save, and try to enjoy their retirement. The whole sorry saga should be condemned from every angle!