Over the last few weeks there has been a great deal of buzz about GameStop. In case you missed it, GameStop is a retail company that sells video games and associated equipment in shopping centers across the country. Due to the recent pandemic, many Wall Street Investors noticed that people are shopping in person less and thus predicted that the GameStop and its stock would go down in price. Some of those investors even made bets that this would happen (by “shorting" the stock).
Many individual investors on an internet forum disagreed with this prediction. In an act of defiance, they decided to buy large shares of GameStop stock and encouraged everyone on the forum to do the same thing. As more and more people bought the stock, the price of the stock increased drastically. The stock price increased from around $20 at the start of the year to over $400 at one point proving the Wall Street investors wrong and causing some of the largest investment firms to lose millions of dollars in the process. Conversely, many of these individual investors who were on the internet forum made thousands of dollars. Many people realized how much money they had made and began to sell the stock to realize their profits. As more people sold their stock, the price of the stock began to decrease. As I’m writing this article, the stock is around $60.
Here are 5 lessons we can learn from GameStop:
1. Sometimes buying individual stocks can make you a lot of money. The GameStop stock price increased from $20 to over $400 at some point. People who purchased shares of the stock around that lower number and sold it around the higher number made a substantial profit. There have been reports of people making thousands of dollars and beyond.
2. If you purchase a stock when it is already near its peak you can lose a lot of money. While many people on the internet forum who bought the stock when it was around $20 made a huge profit, many people who purchased the stock when it was near $300 or $400 were not as fortunate. Because the stock went down in price and is now around $60, anyone who bought the stock higher than this price lost a substantial amount of money.
3. Making money buying individual stocks relies on good timing and good luck. Some people made a lot of money by purchasing the stock and some people lost a lot of money by purchasing the stock. Which group you may fall into if you choose to buy individual stocks depends on many factors, but two of the biggest factors “good timing” and “good luck.” None of us can predict the future, so despite how good we think our guesses may be, making money by purchasing individual stocks has a great deal of risk. Who could have predicted that people on an internet forum would buy stock in a struggling company and cause the price to increase over 600%? Who could have predicted that the price would decrease to $60 less than 2 weeks later? A lot of the profit people make buying individual stocks requires them to buy the stock and sell the stock and just the right point and timing these two things can be challenging to say the least.
4. The prices of stocks can change drastically. In this situation, the price of GameStop stock ranged from $20 to well over $400 and the change happened in the span of weeks. Although changes to stock prices don’t usually have this wide of a range, this situation was a good illustration of a key investment principle: prices of stocks can change and some stocks are more volatile, and likely to have these types of changes more frequently than others. This can be great news for investors who are able to “time the market” and happen to buy the stock at its low point, but this can be hard to do. Stock prices change for myriad of reasons that you can’t always predict.
5. Stock prices aren’t always based on the company’s financials and overall value. GameStop prices changed a lot over the past few weeks, but this change wasn’t based on something that the company itself did. In fact, nothing about the actual business of GameStop or its financial outlook changed. Yet, despite this, the stock price fluctuated a lot. Although this worked out well for investors in GameStop who made profits, the fact that stock prices can change may not be so good for other companies who are more successful. In fact, it isn’t uncommon for successful companies to experience a drop in their stock price despite increasing their revenue and doing good from a “business sense.” Since a company’s stock price isn’t always based on the company’s financials, this makes it more difficult to predict which stocks will earn you a profit and which will not.
My point? Buying individual stocks is risky. You have the potential to make a lot of money, but you also have the potential to lose a lot of money. What actually happens for you depends a lot on luck. To avoid having to rely on good luck, I invest in index funds. This means I own a little piece of all the stocks. This strategy gives me steady profits and also minimizes risk.
Think twice before you buy individual stocks
I don’t actively trade or buy individual stocks, much to many of my friends’ surprise. I mention several reasons why in another blog post, but the main reasons are that:
It takes a lot of work to try to do it correctly
Accurate, timely information on individual companies can be difficult to find
It requires a substantial amount of research on various companies and industries.
The market is volatile and the purchase of individual stocks is too risky
I keep my investing simple by purchasing well-diversified index mutual funds. The index funds lower my risk of losing money and increase my chance of making money. They also increase the odds that I will make a substantial return on my investments over time.
However, I had a few people reach out to me and question this strategy. They asked “if investing in index funds means you purchase all the stocks, then that means you own both good companies and bad companies. Why not just purchase all the good companies individually?”
My answer was that “It’s not that simple.” Let me explain why.
Good company does not mean good stock. In other words, just because you hear of a “good company” like Apple or Microsoft that does not mean buying stock in that company will make you money.
You make money by purchasing stock in a company and having that company’s stock increase over time. Unfortunately, even if a company is good and profitable, that does not mean buying stock in that company will make you money over time.
A company’s stock price is not determined by that company’s value. Some well-run companies can have low stock values and some poorly run companies can have high stock values.
Stock prices are volatile and change quickly based on a variety of factors. If investors think an industry will do poorly over the next few months, their stock price may go down, even if the company itself is doing very well. If investors think a company’s stock is overpriced, they may start to sell that stock which may drive the price down, even if the company itself is still doing well and making huge profits.
Plus, even if a company is doing well and its stock price has increased recently, that does not mean its stock price will continue to go up in the future.
Sometimes a bad company can have its stock price go up (making you money) and a good company can have its stock price go down (losing you money).
It’s hard to predict what will happen.
Picking the right stock relies too much on luck. It is not dependent on skill, intelligence, having the “right” advisor, or extra knowledge. Because it’s so hard to know which companies will have stock prices that will go up over time, buying individual stocks is like gambling in a casino. Although you hope to make money, you can’t predict what will happen. Even if you got lucky and made money initially, that does not mean you will continue to be lucky and make money in the future.
It’s too risky. I’m not sure about you, but I don’t like to lose money. I want to invest in a safe way that will still give me a good return on my investment over time.
I invest in index mutual funds. By purchasing funds like the Vanguard Total Stock Market Index, I am nearly guaranteed to make about 8-10% profit on my money each year. Each year, this return on my investment will continue to increase and compound. This will build my net worth.