I started writing about taxes and new government initiatives in Bermuda, but something distracted me in the markets … GameStop (Ticker: GME). A lot has been written on this saga, and there is much to learn from this. I cannot help but ramble out a few points to consider.

What happened

In short (sorry about the pun), GameStop and a handful of heavily shorted stocks succumbed to what is known as a short squeeze. Shorting a stock is when you borrow shares and sell them on the open market in the hopes to rebuy them at a lower price. A short squeeze is when there is a rush to buy back heavily shorted shares to "cover" this position. Theoretically, shorting a stock leaves you potentially exposed to an infinite loss as stocks can only go down to zero but can go up for ever. Redditors and WallStreetBets readers coordinated a full-on assault against Wall Street and various hedge funds in an "anarcho-capitalist" push by heavily buying stock and out of the money calls to force short sellers to cover. The result was an epic rally in heavily shorted companies and enormous volatility. Emboldened by their success, a growing number of homebound day traders have jumped on the bandwagon.

Some points to consider

1. Anything can happen in the markets

Crude oil prices can go negative, and stocks that are going out of business can rally 1000 per cent. The efficient market hypothesis melts in extreme cases. However, investors may be concerned or appalled by this, but they should not necessarily be "surprised." History is replete with countless stories of bubbles, crashes, and anomalies. Read Edward Chancellor's excellent book Devil Take the Hindmost: A History of Financial Speculation, and you soon see market anomalies have been around since ancient Rome. We will justify all of this with a rational explanation but always after the fact. People who speculate might not want to "miss out," and they often do things they do not understand. The solution is education for the latter. The former, greed, cannot be regulated away. In markets, certainty is not an option. Without risk, however, there can be no return.

2. Risk management should consider market structure

A simple rule for risk management is that you never want an investment that can get you carried out on your shield even if you feel 100 per cent convinced you are right. GME's short interest on the available float was over 160 per cent (this is possible as shares get lent out many times, but we will save the debate on naked short selling for another time). The problem is that when everyone is packed into the theatre with one door and someone yells fire, the stampede creates a massive squeeze at the exit. The fact that this was such a popular short was a warning sign, regardless of whether it was a correct bet or not. Leverage and liquidity are market factors and fundamentals. Risk is not just a game of valuation or solvency.

3. Liberalism and free markets

Markets need to clear. We can debate if this incident is a real market or one heavily manipulated. Still, one thing I disagree with is the closing of markets or one-way restrictions on trading. In the great financial crisis, short selling was banned, and now individual brokers have restricted buying in some stocks like GME. This is not a free market. The initial idea for the restriction on buying was to protect people, but then they noted there were safeguard market-related issues relating to ensuring settlement that Robinhood had to overcome to resume proper market function.

Indeed, one could interpret this disruption as a flaw in Robinhood's business model, which ironically ended up restricting its retail-dominated client base. The very same client base that drove the eye-watering price surges in the first place. Nonetheless, outside of the need to ensure markets' clearing function, halts should be viewed with disdain. I do not think we can protect everyone, nor should we, for most cases.

Market rules and regulations need to be enforced but people need to make mistakes and fail – that is part of a free market and economy. Banning one side of a trade is market manipulation under the guise of regulation to save people. I simply do not believe that a certain group of people, whether they be brokers or regulators, should have the right to dictate the free and voluntary nature of trading. We are building a world where so many groups are now trying to "bubble wrap" everything. It is getting to the point that we are trying to outlaw creative destruction and the evolution of markets and economies.

When people enter trades, they do so, assuming the game will not change hour by hour or day by day. Changing the rules is worse, in my opinion, than letting a market ultimately clear freely. Many will disagree on this point and tilt towards paternalism with the suggestion that in some cases, things are just wrong. To those with that view, however, I would suggest wrong to whom, and whose idea of wrong is correct? We do not want others hurting others, but we also need to make sure people learn from their mistakes and have the freedom to do what they want with their money. Part of this revolt by the retail investors vs Wall Street is the anger over prior bailouts in the great financial crisis. Does Wall Street need a bailout again? Do we ban bubbles and crashes? I worry about where this leads when it comes to freedoms.

Nathan Kowalski CPA, CA, CFA, CIM, FCSI is the Chief Financial Officer of Anchor Investment Management Ltd. and can be contacted at nkowalski@anchor.bm

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