Market volatility in late January had many onlookers scratching their heads at the dizzying rise of some stock prices, and wondering if their investments were affected. Even those who did not own any of the hotly traded stocks like GameStop Corp. or BlackBerry Ltd., likely saw a brief change in the market value of their investments as markets turned volatile. What happened? And what happens next?

What happened?

GameStop became a favourite of the WallStreetBets Reddit group, whose eight million members consist mostly of young, anonymous day-traders. They drove up the stock price from US$4 a year ago, to over US$400 at its peak in late January. At the same time, hedge funds had been shorting* GameStop and a number of other stocks of interest to Reddit’s members. This caused a short squeeze*, and forced the hedge fund managers to buy these stocks at much higher prices.

Investing vs. Speculating

Clearly some of Reddit’s day-traders did well, but GameStop stock fell sharply in the early days of February. “It’s intoxicating to see how easily valuations can run up on a crowded trade into a relatively small stock,” says SLGI Asset Management Inc. portfolio manager, Kathrin Forrest. “But it’s important to consider how this plays out as the party moves to another venue and the crowd heads for the exits.”

For most investors, chasing volatile stocks is not a viable strategy, because it is high-risk and requires close monitoring. Many professional portfolio managers prefer to play the long game: buy and hold companies that have healthy balance sheets and good future prospects. This requires looking at a particular stock’s value through a critical lens: What are the current and forecasted earnings? Does the company’s product or service have a unique, sustainable advantage that the company can protect? Is it in a sector that is seeing increased growth? If the answers align with the stock’s price, it could be a good investment. But if they don’t, there’s a greater risk that any money invested could be lost.

On the other hand, what the Reddit members were doing with GameStop and a few other stocks in late January, was essentially speculating. They looked for stocks that were not expected to perform well, and bet that their price would go up based on internet-hyped demand. “These are generally stocks that have seen a strong increase in daily volume, options activity and strong price appreciation without a meaningful change in underlying fundamentals,” says Forrest. Stock prices were rising, but there was no sound reason for the rise other than artificially inflated demand.

Speculating isn’t new, or even all that uncommon. We can look back a mere 20 years or so to the dot-com bubble. Or all the way to the 17th century’s Dutch tulip mania, and other instances in between. And while some people made money, many others lost their shirts.

It’s also important to note that speculating isn’t always seen as negative. Some investors with large portfolios set aside a small amount to invest in unproven companies that have promising ideas or resource assets, or seek to capitalize on highly volatile securities. Given the high risk of losing money in speculative investments, this is not a mainstream approach.

What happens next?

This latest example of speculative trading has caused some market volatility, and potentially caused investors to get a little bit more nervous about what might happen down the road. Most investors with stocks in their portfolios (e.g. in balanced or equity mutual funds) see short-term fluctuations in their account values when markets are volatile. However, financial advisors can help investors match their tolerance for risk with their need for long-term growth or income.

 

*Definitions

Shorting: Sell securities in advance of acquiring them, with the aim of making a profit when the price falls.

Short squeeze: Happens when the price of a security rises, forcing traders who had shorted the security to buy in order to forestall even greater losses.

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