GameStop, Reddit, and lessons in the social science of stocks

 I need a break from politics.  Let's have some fun with the lunacy of the stock market!

We begin, though, with a moment of sanity.  Here's how the stock market works.  Most people who trade stocks underperform the market average (the S&P 500, or whichever other benchmark you are using).  How can this be?  Simple.  A lot of the money, and a lot of the trades are controlled by big firms and a few people who have very fast computers, and frequently, inside information.  Yes, that's illegal, but only fools get caught.  If that's not you, then you are a fool to trade individual stocks.  Here's the analogy I use.  There are three kinds of critters swimmin' around the financial seas.  Sharks, remoras and prey.  The big financial institutions are the sharks.  If you don't have inside information, super-fast computers, or the like, you ain't a shark.  If you try to trade individual stocks, you get eaten by a shark.  You are shark food, AKA, prey.

The alternative is to be a remora.  You know those weird fishies that swim alongside a shark and gobble up the scraps of what the shark doesn't manage to swallow?  That's a remora.  The shark doesn't eat the remora.  The remora doesn't eat quite as well as the shark, but it does OK by following the shark around and picking up the scraps.

You are not a shark.  Sharks aren't reading this blog.  (Well, nobody reads this blog, but whatever.)  Being a shark is not an option.  So:  remora or shark food.  Take your pick.  Me?  I'm a remora, and I recommend the remora route to riches.  And yes, you can get rich, by a reasonable definition of "rich," following the remora strategy.  Quite simply, if more slowly.  The S&P 500 goes up by about 8 to 10% per year, on average, long-term.  Put your money in a passively managed S&P index, and you get about 8-10% per year, compounded.  Adding money as you can, that's actually a fuckload, presuming you start at an early age.  You aren't going to become Warren Buffett or Bill Gates, but this is the strategy that Warren Buffett tells you to follow, and he's not messing with you.  This is the strategy that most serious financial advisors will tell you to follow, when they aren't just trying to squeeze money out of you for their own paychecks.  Most active managers underperform passive management anyway.  Active managers are con artists.

So, that said, not a lot of people follow the remora strategy.  Particularly those on Reddit.  Reddit, generally speaking, is not the source of wisdom.  It is, apparently, our source of fun and amusement at a time when we desperately need it.  You see, a lot of people are absolutely convinced that they can beat the sharks.  Statistically, some will.  Statistically, you probably won't.  Statistically, if you try, you are what we call, in statistical terms, a "statistical moron."  Statistically speaking, of course.  Anyway, there are a bunch of weirdos on Reddit...

And I could have ended there, but I've got more coffee left, so I'm-a-gonna ramble.  There are a bunch of weirdos on Reddit who think that they can beat the market.  They also dislike this thing called "short-selling."  Quick explanation, and you can find more detailed versions elsewhere.  I've got bigger fish to fry.  (See what I did there?)

Let's say I buy a stock from you at today's price, with an agreement to sell it back to you at the same price a week later.  Who will make out ahead on the deal?  It depends on whether the stock goes up or down in that week.  If the stock goes up, I undercharged you when I sold it back to you.  Oopsies!  If the stock goes down, though, you overpaid on that second transaction.  That second possibility is really interesting to people who expect a stock to go down.  So, they write elaborate contracts to exploit such possibilities.  It's called "shorting" a stock.  Go read about all of the tricks elsewhere.  The financial mechanics aren't really my concern for today.

For today, my fascination is with the Redditors.  A bunch of weirdos on Reddit, for some reason, decided they don't like short-sellers.  As far as I'm concerned, if you swim in the market and get eaten, that's your own fault.  Follow the remora strategy, and you're fine.  More on that, again, later, so I don't care about short-sellers at all.  A bunch of Redditors, though, don't like short-sellers.  But... I do have a fondness for pranksters.

These... do we call them "pranksters?"... decided to fuck with the short-sellers.  Remember that a short has a time limit.  It must.  I can't just say, "I bet you that this stock will go down eventually."  So the Redditors started talking, and observed that if they all banded together and bought a stupid stock, heavily shorted, like GameStop, they would drive up the price, fuck over the short-sellers, and in the process of driving up the price, make profits themselves.

So... fucking stupid, but also, like... coolest prank ever.  This leaves me conflicted.  I have this part of my brain which is the cold, hard, math part.  The economics, rational choice part.  The don't-do-stupid-shit part.  But... then there's this part of my brain that revels in fucking with people.  I mean, come on, you're reading this blog.  If you read this blog, you know I like poking the bear, and you probably see those occasional hints of the bears I am too afraid to poke because of [CENSORED], but let's just take a moment here.  This was either genius in its stupidity, or idiotic in its brilliance, and I can't tell which, but remember that if you're a remora, you are unaffected by this anyway.  This was all a fun show to watch for anyone doing the right thing financially.  And holy shit was it funny!  A bunch of internet trolls collectively bought a stupid stock, drove up the price, fucked over the short-sellers, and in the process...

Created a political scandal when trading platforms halted trading over volatility!

It's funny because it doesn't affect me!  Because I'm a remora!

So let's get into the fun social science here.  Let's say you're some Reddit troll taking a break from conspiracy theories and whatever the fuck else happens on Reddit.  And you see that a bunch of basement-dwellers have proposed this totally awesome prank to mess with short-sellers!  Hey, everyone!  Let's all get together and buy GameStop!  It'll be great!

This gets into what we call a "collective action problem," with the math having been worked out by Mancur Olson in The Logic of Collective Action.  Suppose there is some collective benefit that a group wishes to achieve, but which no individual can provide.  Each individual can contribute some small portion, at a cost.  Does the good get provided?  Generally not, when people act rationally, and Olson derived a bunch of the conditions there.  One of the most important is that the larger the group, and the more required to provide the good, the less likely it is for rational individuals to provide that good.  It takes a lot of people, or a lot of money, to drive up a stock price!

So here's the thing about the GameStop prank.  At the outset, the first batch of pranksters are basically begging to lose money.  GameStop was being shorted because the company is in bad shape.  Stocks are part ownership of the company.  Their prices fluctuate for weird reasons, but they fluctuate around the value of the company.  If you overpay given the value of the company and there aren't enough others to join you, you're left holding the bag stock, and you then have to sell that stock back at something closer to its actual value.  You lose.  You get eaten by the shark.  Welcome to Prey-town.  Population: you.

The prank only works if there are enough initial people who are irrational.  Who buy above the value in the expectation that others will too.

But... they did.  That's what's weird.  And the thing is, as the price goes up, that initial batch of buyers finds that they have made a profit by buying stocks for which they overpaid!

Yes, it is possible to turn a profit on a stupid bet.  "Irrational" does not mean "mathematically impossible to make money."  The fact that you made money does not "mathematically prove" that you made the "correct" decision.

Let's say you have a coin.  A fair coin, a real coin, yadda-yadda-yadda.  Let's say we place a simple wager.  $1000.  We bet $1000 on the following.  You bet that a series of four coin tosses will result in heads-heads-heads-heads.  I bet that it will not result in heads-heads-heads-heads.

Is it possible that you will win that bet, and hence, win a grand from me?  Yeah.  What are the chances?  There's a .0625 chance that you'll win.  On a straight $1000-for-$1000 bet, I'll take those odds any day of the week and twice on Sundays in a gleeful act of blasphemy.  I might lose, and if I do, I'll pay up like a big boy, knowing that I made the right call and that you're a fuckin' idiot.  If you win, you got very, very lucky.  It does not "prove" that you made the right bet.  You still can't do math, because if you enter a bet with a 6.25% chance of victory and it's only paying even money... you suck.  You just suck.

But iterated over enough observations, sucker bets will sometimes win.

The Redditors who started buying GameStop won, by getting enough people to follow them.  To make a crass and inappropriate scholarly reference, Dennis Chong wrote a very good book about the civil rights movement, elaborating on Olson.  Collective Action and the Civil Rights Movement.  Chong noted that the first people to engage in civil rights protests-- the early leaders-- were the ones who bore the costs, but in doing so, lowered the costs for the subsequent protesters.  That's kind of what happened.  Once the price of GameStop started going up because of that first round of people taking the risk, you had algorithmic trading going on.  Subsequent buyers could then buy with less risk because rather than just buying against the strict value of the stock itself, they could gamble that the Redditors as a group were creating an upward trend, that would, for a time, sustain itself.

"For a time."

At that point, the short-sellers were already fucked.  Point made, prank successful.  If you are a Reddit GameStop buyer here, that's the point at which you just sell.  Take the profit.  You gambled-- as opposed to invested-- and won.  Get out while you can.

Because at this point, it's a pyramid scheme.  Once the stock is so far above its value, someone will be left holding the bag.  And you don't want to be that person.  Along the way, though, as I said, you can make a profit buying a stock above it's value!  Just as people in the middle of a pyramid scheme can turn a profit!

This is an important observation.  Scams don't screw over everyone.  Pyramid schemes only screw over the people at the bottom, and the trouble is trying to figure out where the bottom is.  The reason you should never get involved in a pyramid scheme is that you can't tell if you will be at the bottom.  If you're not, you can make money!  But if you count on not being at the bottom, you're an idiot.  Same principle as my sucker's bet, posed above.

So now we come back to the always-controversial and always-misunderstood "efficient markets hypothesis."  Basically, market prices will tend to converge to the actual value of an asset.  This does not mean that the market always gets it right, nor that you can't ever make a profit buying something at a stupidly-inflated price.  Bubbles happen, and they can remain inflated for a long-ass time.  But there has never been an asset that people have been able to ignore, and just say, well hey, this'll always go up... and get away with it.

And yes, this is still going on with cryptocurrencies.  People are still inflating and deflating stupid bubbles with cryptocurrencies.  Hey, bitcoin is going up!  I better buy bitcoin!  Oh, fuck!  Bitcoin is crashing!  Sell!

You know what has still not happened?  There has still never been a utilitarian case for the individual consumer to exchange dollars for bitcoin, at a transaction cost, in order to conduct commerce in bitcoin.  I have been pointing this out for years, and noting for years that this case has not even been made at the theoretical level.  It will not be made.  Moreover, a currency needs to be a stable store of value, so even when bitcoin is going up in value, that negates its utility as a currency because anyone holding bitcoin would be stupid to spend it.  Bitcoin is the stupidest fucking thing ever.  Pure speculation for the sake of speculation.  Can that go on for a long period of time?  Yes!  Can individuals make money in the process, even though it's stupid to do so?  Yup.

Just like the GameStop people.

And just as stupid.  At least the Redditors buying GameStop have the excuse of a prank.  Bitcoin-bugs are just annoying.  I kinda like the GameStop people, if I'm being honest.  They're idiots, but they successfully pranked some self-important assholes, and anyone who gets involved in individual trades... well, you pay your money, you take your chances.  Nobody gets any sympathy from me.

Remember, just be a remora and you can laugh at all of this.