Opinion: What We Can Learn From the GameStop Saga on Wall Street

A David and Goliath saga playing out on Wall Street has attracted global attention.

At the center of the saga is GameStop Corp., a 36-year-old video-game retailer. The company’s stock has been climbing since the start of 2021, boosted by rising video-game sales as a result of the Covid-19 lockdowns. But short seller Citron Research last week predicted the stock would crash, saying its improvement in sales was not enough to support the stock price.

A group of hedge funds led by Melvin Capital and Citadel LLC heavily shorted GameStop’s shares. This common strategy for betting a stock will fall involves paying a fee to borrow shares, selling them and planning to buy the stocks back at a lower price to return to the lender, pocketing the difference.

But individual investors on the popular investment social media forum Wall Street Bets threw their collective support behind GameStop, calling for people to buy the stock to fight the Wall Street short sellers. In a matter of days this week, GameStop’s shares have soared more than 400%, forcing the short-selling hedge funds to buy at a higher price to close out their short positions, taking an estimated $5 billion loss.

As bystanders in China, what lessons can we take from this epic saga?

The first is a rethinking of the roles of institutions and individual investors in the stock market. In traditional financial theory, individual investors are often given the politically incorrect name of “noise traders.” Many researchers presume that institutional investors are rational and individual investors are irrational. Institutional investors are responsible for setting prices, while individual investors’ main role is basically to add noise, or confusion. Many empirical studies have repeatedly shown that in both the Chinese and American markets, 80% of individual investors lose money and very few make money.

Why do individual investors lose more money than they make? One explanation is that they often have a lot of bad trading habits, such as frequent trading, which makes them pay very high transaction fees over time. Individual investors often have a “disposition effect,” the tendency to sell a stock that has increased in value while keeping stocks that have dropped. These explanations are supported by a lot of empirical data.

Another explanation is that individual investors may be taken advantage of by speculators among large institutional investors through price manipulation. There is not much direct empirical data to support this theory, but there is some indirect evidence showing that in some years of stock market volatility, the total amount individual investors lose in the entire market largely matches the total amount institutional investors make.

Moreover, traditional finance theory also holds that in the long run, individual investors losing money may not be a bad thing for the stock market as a whole as it helps make market prices more rational. At the same time, if individual investors put their money in the hands of institutions, they can also share in the profits made by the institutions.

However, not everyone is satisfied with such explanations. People may wonder whether the fact that institutions earn more and lose less while individuals earn less and lose more necessarily means that institutions are always rational, always right, and individuals are always irrational. Or does it mean market prices most of the time reflect the views of institutions, simply because institutions have more information and more pricing power than individuals?

In fact, even in the classic theory of efficient markets, the definition of an effective market should refer to a market as an information aggregation mechanism that reflects all known information from all market participants — no matter whether the information is right or wrong, or more rational or irrational. If a market’s power of voice and pricing is always monopolized by a few opinions with a higher degree of rationality and ignores the information with a lower degree of rationality that may be complementary in some aspects, is this market really the most efficient?

The most recent battle on Wall Street shows us how times have changed. Thanks to the internet and new technologies, retail investors have changed from individuals with little or no voice to a group that can be connected through social media.

GameStop is a case study. Personally, I agree that based on its fundamentals, even if the company goes through a radical transformation in the short term, it is difficult to support the current high stock price. At the same time, in every stock market there are a number of stocks for one reason or another that have maintained ultra-high price-to-earnings ratios for quite a long time. GameStop, supported by individual investors’ faith, is one the them. Many big tech companies and unicorn startups chased after by large institutional investors are no different. High stock price and low profit or even no profit have long coexisted in these stocks. Under these circumstances, it is hardly fair to hand a “death sentence” to a company with many kinds of possibilities simply based on a single report from one institution.

In fact, with the development of research on financial markets, many economists and researchers today no longer take a black-or-white position on topics like market efficiency and bubbles as they once did. For example, according to recent developments in macroeconomic research on “rational bubbles,” moderate asset bubbles can provide liquidity for economic growth, ease financing constraints and increase productivity. Applying similar thinking to the financial markets, one can also argue that the short-term divergence between the stock prices of growth companies from their earnings actually results from a combination of start-up costs and “disruptive innovation” in new industries.

At the same time, as many heterogeneous-agent models have pointed out, because collecting additional information and making more rational decisions require more input and cost, financial markets may have an inherent tendency to alternate between rationality and chaos. When the market is booming and everyone can make a lot of money without spending a lot of energy on research, more people will choose to do whatever they want instead of researching, resulting in a shortage of effective information supply and sowing the seeds for a market crash.

However, when a crisis breaks out and the market is in uncertainty, everyone knows that if they do not study carefully, they will lose a lot of money. This will make more people seriously collect information, resulting in improvement in the quality of market information and effective allocation of capital, leading the economy to prosperity again.

In the case of GameStop, on the one hand, I agree with many experts that in the long term its current high stock price will be difficult to sustain or at least faces some correction. On the other hand, although we won’t see the possibility that social media-driven individual investors will replace institutional investors as the main market force in the near future, this historic saga opened the door and the door is unlikely to be closed again.

The days when stock pricing was determined by a small number of elites and institutions should be over. The future of financial markets is bound to hear more voices from the young generation and witness the emergence of more grassroots heroes.

Bao Te is an assistant professor of economics at Nanyang Technological University in Singapore. He earned a B.A. in economics from Fudan University in 2006 and Ph.D. in economics from the University of Amsterdam in 2012. His research interest is experimental economics and behavioral finance.

Translated by Denise Jia (huijuanjia@caixin.com).

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