By now, most of you have heard about GameStop stock and its wild run this year. I’ve received a number of questions from investors about GameStop, so I thought I would answer them here. The number one question I have received is what happened with GameStop stock?
The GameStop saga can be looked at as a David vs. Goliath story. David being amateur everyday investors, where Goliath is the hedge funds. Hedge funds have been shorting GameStop stock for some time.
This means they have borrowed shares of GameStop and sold those shares hoping that the stock price would fall. This way, when they return the shares that they borrowed, they would do so at a much lower price. In other words, short sellers are hoping that the stock price falls; that is how they make money. Unfortunately for the hedge funds, amateur investors on Reddit, a social media forum, noticed that hedge funds were heavily shorting GameStop stock and in order to punish the hedge funds, started encouraging investors to purchase the stock.
As a result, when you have more people wanting to buy the stock than sell it, the stock price rises, and that is exactly what happened. Millions of individual investors got caught up in the frenzy and started to purchase GameStop. As the stock prices started to rise, the hedge funds realized how much money they were losing and thus, to cover their short positions they also started buying stock which, once again, resulted in the stock price rising. As a result of all the buying, GameStop stock surged in value. Of course, not surprisingly, as the frenzy started to wane the stock has fallen dramatically. The stock which was selling for over $480 a share a week ago, has fallen to $50 a share now.
Over the years, many investors have also asked me if I recommend that they invest in hedge funds. My answer is generally no. First of all, hedge funds are generally not available to the average investor. Because hedge funds are not as regulated as other investments such as mutual funds, they are limited to accredited investors only.
To be an accredited investor you must have an annual income exceeding $200,000 or have a net worth of over $1 million. In addition, hedge funds typically employ a variety of sophisticated techniques to maximize returns over the short run. To me, when you look to maximize profits over the short run, it is more akin to gambling as opposed to investing.
Furthermore, many hedge funds are highly leveraged in order to increase their potential returns. This can be very profitable; however, it also can be extremely risky.
In addition, it is incredibly difficult to obtain independent information on hedge funds. Most hedge funds are stuffed with high fees and often tie up your money for a period of time. This means that unlike mutual funds, where you can sell your investment any time you choose, hedge funds require you to keep your money invested for a period of time.
If you are an accredited investor that is already well-diversified, and you are looking to invest a small portion of your portfolio into something aggressive, a hedge fund is something that you may wish to consider. However, remember that not all hedge funds are the same and before you invest, make sure to do your homework and understand the investment and the risks involved.
Rick Bloom is a fee-only financial advisor. His website is www.bloomadvisors.com. If you would like Rick to respond to your questions, please email Rick at firstname.lastname@example.org.
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