“Things that have never happened before happen all the time,” wrote Scott Sagan, and while he was referring to mismanagement of nuclear materials, I think his words are certainly applicable to recent market events.[1] There are two lessons, maybe three, we ought to learn from GameStop’s shocking rise last week. First, that unexpected “black swans” seem to happen almost on a regular basis. In the last 40 years, the market dropped 22.6% in one day, October 19, 1987. In 2000, the dot-com crash took the NASDAQ down 80%. In 2008-09 the Great Recession took the market down 37%. And, of course, 2020 saw the pandemic.

Things that have never happened before happen all the time.

The second lesson is to never underestimate the power of social media and community. In Tunisia in 2010, when a man set himself on fire, by the next year that sentiment toppled the governments of Tunisia, Egypt, and Libya, spreading across the Arab world. By the end of the uprising, over 22 million, mostly young, Arabs were active on social media.

So what does that have to do with GameStop? It is the power of social media and community to create an event that had never happened before.

Reddit is a social media messaging site, and one such board is r/WallStreetBets. It is a “board” where users post information about stocks. These types of boards have existed on Yahoo and other sites for several decades. The people posting to the boards may post memes (internet photos, characters, opinions on various stocks) and some will even post their confirmations and monthly statements showing how profitable their trades have been. r/WallStreetBets grew to nearly 2 million members by mid-January of this year. Many users of the board are day traders.

Robinhood is a broker-dealer set up with zero commissions and zero minimum. It is my understanding that trades for a few dollars can be made in stocks and even cryptocurrencies. As the name implies, the broker was set up to provide everyone with access to the financial markets, not just the wealthy.

Melvin Capital is a hedge fund funded by Gabriel Plotkin with a bottoms-up approach to long and short portfolios. Plotkin was a star portfolio manager at SAC before starting Melvin Capital in 2014. He was short GameStop.

That was the situation when the Reddit board day traders, all with limited assets, began to band together and buy GameStop. I would guess many of them actually had a personal connection with the store and were shoppers, not just investors, because GameStop had brick and mortar stores in malls for decades before the dual decline of malls and the pandemic sent it downhill. They saw the short position and began to buy small positions, and, in the way of memes, spread through the community.

Most investors are “long buyers,” buying stocks with the expectation that the stock will increase in price. “Short sellers” borrow stock and sell a stock they have borrowed with the objective of buying that stock back at a much lower price to replace the borrowed shares. When buying stocks long, the most an investor can lose is the amount that the buyer paid. For a short, the stock can increase infinitely. The potential loss can be huge.

The number one rule for short sellers is to “cover the short” position by buying the shares to replace the ones borrowed when the stock “moves against you” by increasing in value. The number two rule is never forget the number one rule. The number three rule is never forget the number one rule.

I have to wonder if Plotkin and the other hedge fund managers who had shorted the GameStop stock didn’t continue shorting even as the stock was increasing in value. After all, they were supposedly the “sophisticated portfolio managers”. I have heard them say the buyers were “brainless idiots”, “amateur day traders”, and “retail nerds”. The hedge fund managers were the “smart money” people. There are newsletter and writers who talk about what the “smart money” is doing.

The “smart money” portfolio managers knew that retail investors had never brought them down. It had never happened before in history. Their computers and algorithms showed it had never happened before. How could this time be different?

Those “brainless idiots” were posting on the reddit board and displaying their confirms showing the thousands and millions they were making each day. The board exploded adding 500,000 new users in a week.

“Things that never happened before happen all the time”.

Melvin Capital began with $12 Billion under management and suffered a 53% decline. All told, the “smart money” hedge funds lost $19 billion, and that amount probably understates the actual losses.

Meanwhile some – or maybe a number – of those “brainless idiots” were using the profits to pay off student loans and mortgages on their homes.

The Incentive Profit Sharing Account at Adams Financial Concepts uses the long/short strategy to improve returns and cushion the downsides. I will never forget rule one, two or three. I know not to underestimate the power of a community. I know that things that have never happened before happen all the time. I want to build what I call a “Margin of Safety” for clients. That Margin of Safety is having more than planned for.

Forecasts and plans are great. But the old saying is this: “We plan; God laughs”. As the poet Robert Burns wrote: “The best laid plans of men often go awry”. We want to have sufficient funds available that, when things that have never happened before do happen, we can weather the storm.

[1] Sagan, Scott. The Limits of Safety. Princeton University Press; 1st edition (January 9, 1995).