David vs. Goliath? – Jan Schmitz


David vs. Goliath?

By assistant professor Jan Schmitz

Most of you probably have heard about the GameStop hype on the stock market and the “fight” David (retail investors) versus Goliath (hedge funds). For those who have not, here is a short summary: GameStop Corp. is selling computer games in physical stores and is struggling for years because most of the business of selling computer games has moved online (e.g., revenues declined by 30% from 2019 to 2020). Not surprisingly, GameStop was the target of hedge funds betting on decreasing share prices. As a consequence, GameStop was heavily shorted by several hedge funds (i.e., the hedge funds borrowed shares from other investors (for a fee) and sold them for a what they thought high price hoping to buy them back later for lower prices and cashing in the difference). Now, one would think that betting on decreasing stock prices of a company that sells computer games (which are often played and sold online) in a physical retail store (let alone in Corona times) is not an entirely bad idea. It turned out though that an army of retail investors (calling each other retards, autists or apes) coordinated on wallstreetbets - a sub-reddit of the discussion forum reddit - to buy stocks of the company thereby increasing the share price and put the hedge funds into trouble.

Hedge funds oftentimes have aggressive investment strategies where some make money as other market participants suffer. Unsurprisingly, they don´t have the best reputation and are associated with market manipulation and hurting individual investors and businesses. They have been criticized before, but what is new now is that a critical mass of retail investors succeeded in bringing these big hedge funds into trouble. After the “reddit army” coordinated on buying GameStop shares, the share price surged (by about 1700 percent)  and the hedge funds needed to buy back shares to much higher prices to cover their short position. Thus their bet on a falling stock price was crossed by the individual investors who pushed the stock price up. As a result several hedge funds got into financial trouble and some so called “experts” on the stock market saw the entire financial system collapse as they feared that the hedge funds need to close other positions to cover their losses. The fear was that this will substantially impact share prices of well performing companies leading to a downward spiral jeopardizing pensions and investments of hard working people. Luckily, this did not happen. But what might have happen is that a potential new “player” emerged on the stock market as retail investors realized that if they coordinate they may have an impact on financial markets.

So why am I telling you all this? There are multiple other sources where you can read up the entire story of wallstreetbets, the “GameStonk hype” and the consequences thereof (e.g., trading apps for example banned buying of GameStop shares and only allowed selling thereby heavily intervening in the market which likely has legal and potentially regulatory consequences). This time of the year, however, many students at Nijmegen School of Management at least are looking for topics for their Bachelor or Master Thesis in Economics or Finance. So besides being an interesting topic also for those who have not heard about it, it may serve as inspiration for those looking for a topic for their thesis. The “GameStop vs. Wallstreet” fight will likely have implications for financial regulation and further, it presents some interesting developments in behavioral economics and behavioral finance.

In my opinion, this example highlights several phenomena at the same time: First, it shows that there are many (especially young) people who have substantial monetary resources to actually invest in the stock market – something you should not really do if you don´t have the monetary resources since stock prices can also go south quickly. So a lot of people are really well off which I believe, is a good sign. Second, ins spite of people being relatively well off there seems to be a substantial discontent with the current financial system and people are willing to potentially sacrifice resources to punish established players in the market. Third, new technological developments (stock market forums as well as trading apps with low fees) allow people to coordinate and, importantly, put their plan into effect.

Considered in isolation, these phenomena are not new. We know from behavioral and economic research that, e.g., communication may help to achieve outcomes and that people are willing to sacrifice resources to punish others. We also know that people are influenced by what others’ do and are likely to follow their behavior. But we also know that sustaining cooperation is difficult in situations like these where everyone needs to contribute in order to achieve an outcome. The reason is that each actor oftentimes has an incentive to free ride (e.g., in this situation: sell when the price is high which will drive prices down again). Importantly this is also what the hedge funds thought and shorted even more. The retail investors, however, kept the price up for longer than expected by the hedge funds.

Thus, the interplay of social motives to sanction potential wrongdoers in the market, individual investments and new technologies helped the emergence of the retail investment crowd as a new player in the market. It is going to be interesting to see how the story goes on: Will the retail investors be able to cooperate for a longer period of time? Or will this turn out to be a big “pump and dump” – Ponzi scheme like investment where it is profitable if one is one of the first investors and really costly if one is too late and invests if the price is already very high?

In fact, the GameStop share has considerably lost in value already but the reddit army has partially moved on targeting other stocks. I am curious to learn more about the mechanism and motives behind this. Maybe some of you study this in their (bachelor or master) theses and contribute to the general understanding of how and why (especially young) retail investors coordinate in the future? Do they coordinate because of social motives to change the rules of the investment game and punish hedge funds or because they realize that new investment platforms enable them to execute significant market power to influence stock prices?


Word of thanks

Once a month there will be published an article written by one of our teachers economics at the Radboud University. We really appreciate the contribution of the economics department a lot. This month we may thank Jan Schmitz, professor of Financial Economics, for his article about the retail investors versus hedge funds concerning the Gamestop hype.