Updated: Oct 18, 2021
Recently, I have found myself drawn towards the stock market as a way to learn a new skill in quarantine and make some money. Over the past two months, I have watched as friends made several times what I make from a day of work on a single trade. However, a lot of their trades have been based on hype and the conditions of the currently volatile market, making them more akin to bets than actual investments.
As of late, stocks seem to only go up, especially recent hits GameStop (GME), Snapchat (SNAP), and Tesla (TSLA). However, we are also experiencing highly volatile and speculative market conditions which have created as much risk as reward.
Although the market appears to be generally going up, it has had bouts of extreme volatility, especially in sectors that have a long lead time before they show a profit, such as tech and biotech. In a volatile market, stock prices change rapidly and unpredictably, and increased volatility usually takes place in periods of increased uncertainty.
VIX is a commonly used metric to measure market volatility. Spikes in VIX tend to correspond with events that create uncertainty, for example spikes in COVID infection.
VIX (Volatility Index) over the past 6 months
Along with being volatile, the market is currently very speculative. This means that
investors are buying stocks based not on the current profitability of the corporation, or even on the expectation of future profits, but on the hope that the stock’s price will continue to rise as demand increases.
The values of many tech stocks, like Tesla, are largely based on this kind of speculation: Investors are, in effect, betting that someone next week will pay more for their stock than they paid for it this week. Tech stocks currently make up over 27% of the S&P 500, and the sector has huge growth potential. But it is speculation, rather than expected earnings, that is driving many of these prices up.
Another example of large-scale speculative behaviour is that of the Reddit investors betting against private hedge funds on GameStop. GameStop’s retail model led to its stock collapsing over the past few years, as video games increasingly became a fully-virtual product. Some large hedge funds heavily shorted the stock, planning to buy it in the future at a reduced price. To take revenge on the hedge funds for what they saw as market manipulation, Reddit mobilized a mass individual buying campaign for GameStop stock, driving its price sky-high and causing billions of dollars in losses to the hedge funds. Now, it seems unlikely that GameStop will be able to make the profits that would justify its skyrocketed stock price. While the rise of Gamestop was a wildly unpredictable and unparalleled event, there is a lesson to be learned from the hedge funds’ losses – don't short too aggressively – and from those who came too late to the party – don't buy at the top of a bubble.
Speculative investments like these provide market liquidity, which means that more people are willing to be the counterparts in a trade, and having more people investing is always better because it helps markets stay flexible and creative. But such a speculative environment carries serious dangers, too.
John Maynard Keynes, one of the most prominent 20th-century economists, explained the dangers of speculative investing in his 1936 General Theory of modern macro-economics: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done…” Keynes is essentially saying that speculative investment becomes dangerous when it occupies too large a share of the overall market. Unfortunately, we may be entering that stage of the stock market.
What does this all mean for a teenager looking to invest a bit of their paycheck? As we enter a period when investing in stocks is easily conflated with betting on them, every investor needs to be aware of where they are putting their money and why. If you are interested in putting money into the market, are you trying to invest in a company because you think the profits will go up? Or are you betting on a stock because you think the stock price will go up? These are both potentially valid strategies, but as we enter an increasingly frothy market, you had better be able to identify which one you’re using. Rather than picking individual stocks, risk-averse investors should consider investing in an index fund or ETF to better diversify their portfolio; few individual stock-pickers have been able to beat large index funds over long time scales. And remember the key rule of stock investing: “Buy low, sell high.” Not the opposite.