The Five Forces That Doom GameStop-Type Strategies

It’s a brand-new day. The new social-media-savvy traders have pushed aside the oldsters and are having a field day. They’re even taking on multi-billion-dollar hedge funds and winning! Except…

… the historically fast-paced activity is running pell-mell towards a head-on collision. The problem isn’t any one thing. It’s five grim dangers that are being ignored or misunderstood.

These five threats, at best, will kill the traders’ presumed golden goose. More likely, though, the final payoff will be loss and dismay.

Wall Street – Professional traders and fund managers know a thing or two about taking advantage of securities running amok – and the investor-traders that are causing the melee. While the GameStop GME action is being used as proof of superiority by the new traders, the real result is that it has awakened the lions.

Fundamentals – Like it or not, in the end, a stock’s price is based on its fundamentals. While sudden demand can drive a stock up, the eventual top price will sit atop air. Fundamentals’ gravitational pull then starts the drop back to realism. This decline goes from a dip to a correction to a plummet as the previous winners scramble to keep a profit while Wall Streeters pile on.

Social media togetherness – Two problems with social media group-think and crowd-action. While powerful when coordinated, it is destined to fragment when times get tough. Once the reversal begins, a panic race for the exit begins, with each person attempting to be at the head of the rush.

Leverage – Oh, so wonderful to put up $10,000, buy $20,000 worth of stock and have it double. $10,000 becomes $30,000! Of course, GameStop has enticed people to dream or even believe that turning that $10,000 into $1 million quickly is possible. Today, GameStop started teaching the other leverage lesson: wipeout.

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Hype – This peril comes from the fact that social media investing “friends” could be fiends. Age-old stock investment cons are manipulation and fraud. Here is the FBI’s description from their “Common scams and crimes” section to educate the public (underlining is mine):

Market Manipulation (“Pump and Dump”) Fraud

Market manipulation fraud—commonly referred to as a “pump and dump”—creates artificial buying pressure for a targeted security, generally a low-trading volume issuer in the over-the-counter securities market largely controlled by the fraud perpetrators. This artificially-increased trading volume has the effect of artificially increasing the price of the targeted security (i.e., the “pump”), which is rapidly sold off into the inflated market for the security by the fraud perpetrators (i.e., the “dump”). This results in illicit gains for the perpetrators and losses for innocent third-party investors. Typically, the increased trading volume is generated by inducing unwitting investors to purchase shares of the targeted security through false or deceptive sales practices and/or public information releases. 

Tips for Avoiding Market Manipulation Fraud: 

  • Don’t believe the hype
  • Find out where the stock trades
  • Independently verify claims
  • Research the opportunity
  • Beware of high-pressure pitches
  • Always be skeptical

The bottom line: A good investing education has hard knocks – Don’t let them take you out of the game

So many “hot” stock discussions today are overly simplistic. And yet they come across as confident and well supported. Therefore, be very wary. During my career, I kept a sign in my office: “Question everything.” It’s the only way to arrive at the best decisions in investing.

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