The Impact of the "Short Squeeze" on Your Long-Term Investments

The big news on Wall Street lately involves a bricks and mortar video game retailer (among others) and a Reddit community called WallStreetBets. Shares of GameStop (GME) skyrocketed recently as retail traders applied what’s known as a “short squeeze,” sending some hedge funds into panic mode.

Here’s how it works: Hedge funds, which are institutional investors, look for stocks that will likely decline in value. If they find one, they’ll borrow shares from a broker and sell them. When the stock price gets low enough, the hedge fund will repurchase the shares and give them back to the broker, pocketing the difference between the sale price and the repurchase price. This is called “shorting” the stock.

But in the case of GameStop, retail investors connected to WallStreetBets apparently decided to upend the legal hedge fund process by pumping their own money into the stock, driving the price upward and forcing the short sellers to repurchase their shares quickly so they could cut their losses. As reports, the frenzied buying by short sellers drove the stock even higher, which led to a vicious cycle of more panic buying. This is the short squeeze.

Once the GameStop gambit caught fire, online traders have tried their pump and dump strategy with other companies, like AMC Entertainment Holdings, and silver futures, creating even more noise in the markets. It’s unclear how long the trend might continue, so should you be concerned? Let’s take a closer look.

Q4 2020 Market Review

What Stock Prices Reflect

The amount you pay for a stock reflects several factors, such as supply and demand. But, as Wes Crill of Dimensional Fund Advisors points out, it also reflects discount rates applied to the company’s expected future cash flow. If the stock price rises, that could mean that expectations of cash flows have gone up, or that the discount rate went down. If the discount rate went down, a price increase means lower expected returns.

At AMDG Financial, we rely on empirical data to identify stocks with higher expected returns. While news headlines can affect individual stocks or entire markets in the short term, history suggests that short-term highs and lows don’t provide evidence of future returns. In creating strategies for our clients, we focus on, or “tilt,” toward securities that have higher-than-expected future returns. Historical data shows that in both the U.S. and international markets, value stocks and small-cap stocks have produced significantly higher returns than broad market indexes over time.

Day Trading Vs. a Long-Term Approach

Day trading, the practice of buying and selling individual stocks to capitalize on intraday market prices, has become more popular since the beginning of the COVID-19 pandemic. As I wrote last year, one reason for its popularity may be that it feels similar to gaming or gambling. Stories of big gains in a short period of time can lead retail investors to experience “fear of missing out,” or FOMO. Emotional investing, based on feelings of fear, greed, or even boredom, can end in disastrous results, especially among those without investing experience, or whose only goal is to get large returns quickly.

One reason we prefer investing in Dimensional funds is that they aren’t available to the public at large. Investors can only access DFA funds if they work through a Dimensional-approved firm, such as ours. Firms that understand and buy into DFA’s investment philosophy are more likely to invest consistently on behalf of their clients ­­— through good markets and bad ­­— maintaining exposure to securities with higher expected returns instead of making damaging changes to their investment plans during times of high market volatility. Dimensional tracks more than 400,000 securities around the world, but its research process extends deeper, exploring real-world dynamics of portfolio design and architecture, price momentum, trading efficiency and tax management.

 The Importance of Staying Focused

There will always be buyers and sellers on Wall Street, and each side will always think the markets will move in their preferred direction. While the David and Goliath theme of individual investors taking down big hedge funds might seem compelling, it’s likely to end badly for the Davids in this story who are risking their hard-earned savings. Hedge funds will be in a better position to absorb their losses, while individuals who lose may never recover. Our advice? Tune out the noise and stay focused on your goals. Your future self will thank you.

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