At Cornell over a decade ago, Bill Tayler and his colleagues wanted to understand why smart investors would not bet against a bubble and gathered a group of participants to trade shares in an artificial company with a simplified stock market.
The participants were told that there was a computerized trader who could buy stocks continuously, causing prices to go up. During the trading, a majority of the participants bought shares, assuming the prices would go up as a result of the computerized trader.
This strategy led to what is called a short squeeze, which is exactly what was seen with GameStop stock. It all ended with participants selling their stocks to get out before the crash and the ones who made the most money bought early and sold before the crash.
This mock market was a mirror image of what happened with GameStop stocks.
Short selling was described by Tayler as a way to bet against stock prices. He then translated the GameStop saga into an easier-to-understand hypothetical.
Say a friend wrote a book that is currently selling for $10. You have read that book and think that the sequel is not going to be as good as the first book. You think the true value is $5.
You ask to borrow the book from your friend and sell it for $10. A couple of weeks later, the book is selling for $5 on Amazon and you buy it back to return to your friend. The friend gets his book back and you just made $5.
The flip side of that story has the price of the book going up and you have to buy the book back for more money, which is known as a short squeeze in the stock market.
“You can make money on short selling if you’re right and the price goes down,” Tayler said. “You could also lose a lot of money if you’re wrong and the price goes up.”
The factors that fed into this GameStop bubble were the hedge funds that bet heavily against the stock and then the Reddit users that came into the market to drive the price up and cause the short squeeze, which drove prices further.
“Another part of the reason they wanted to get in is because they realized, if we stick it to the hedge funds and we cause this short squeeze, the price will go up even more and we can make money from that,” Tayler said
The Reddit users may have wanted to stick it to the hedge funds, but there were other factors that made the bubble as big as it became.
Social media came into play with people hearing about the race to buy GameStop shares. While everyone laughed about hedge funds losing money, many hedge funds got in on the GameStop stock bubble and also made money.
This was a big piece that many missed, according to Tayler, which was the fact that it began as an attempt to hurt hedge funds but that many big investors made out with some big money from the market.
“Yes, some hedge funds got totally hung out to dry, but there were other hedge funds, smart traders, wealthy investors, and the everyday average investor that drove that price up,” Tayler said.
As the bubble burst for the GameStop stocks, the share prices came plummeting down as people began to sell shares and cash in. Tayler said it was all about timing, with many holding on to shares too long or getting into the market too late and then losing money.
“From the research I’ve done, when we ran experiments on this, you see this type of bubble form in this type of market often,” Tayler said. “It’s a natural outcome of the setting that existed with GameStop, but another natural outcome is that people learn. The wealthy investors learn, ‘Don’t bet against a bubble early on.’ If you’re shorting a bubble early on, you’re going to get decimated. Other investors learn to get in early, but they also learn to get out early enough that they can make serious money on it. What happens is, people, get out early and then they get out earlier the next time and earlier the next time because everybody is trying to get out before the market crashes.”
This learning process was shown by another bubble that formed at a similar time: the AMC stocks. Tayler said that is why the bubble burst as early as it did.
Tayler went further, bringing up that for every story told about how someone paid off their student loans or a mom bought her son shares three years ago and cashed in, there are the stories of major losses.
As for the biggest message Tayler took out of the GameStop bubble, he said it was one that was interesting and concerning.
“Everybody is seeing the big wins of their friends on Facebook or maybe even people they don’t know, and there is a bit of FOMO (fear of missing out),” Tayler said, “‘I missed out, and I don’t want to miss out next time.’”
Now some may go on to open RobinHood accounts and take rent or grocery money to put in. Tayler said he is a huge fan of long-term investments, but warned that short-term investing can be risky with the stock market being as volatile as it is.
He wants people to be aware of the risks that come with short-term investments while making sure they are willing to lose all of the money they put in.