My first exposure to finance was a high school class on markets where we were required to read Peter Lynch’sOne up on Wall Street. About 25 years later, including many years of studying economics and finance, what we were taught about investing seems crazy to me: that good investing entails picking the right stocks, stocks that will make money.
This is wrong because it leaves out one of the major objectives of finance: managing risk. Yet this is how most people think about investing; we teach it in schools and we see it in our culture. A few weeks ago, we cheered on small day traders who, for a few days, anyway, appeared to get the better of hedge fund short-sellers. And it was a compelling story: In these times of stagnating wages, rising inequality, and seemingly endless rewards for financiers, few things are more satisfying than watching the little guy get a piece of the action. The GameStop saga was heralded as the democratization of finance—which happens to be the stated mission of the Robinhood trading platform. Easily accessible brokerages aim to make stock speculation easy for retail investors and have contributed to popularizing stock trading during the pandemic.
But the ending of this story was predictable. Prices of GameStop crashed and many investors lost money. Not because markets are rigged for hedge funds or because Robinhood restricted trades their users could make, but because this is how stock speculation normally goes, the prices of individual stocks constantly go up and down and by any reasonable measure GameStop and AMC’s prices were overvalued. Speculation is extremely risky and it is extremely hard to time it, especially when options are involved which have the potential to magnify gains and losses.
This week, the CEOs of Robinhood and Reddit will appear before Congress to investigate why small traders were restricted from buying more stocks like GameStop. Senator Elizabeth Warren, who made her career by casting herself as the hero fighting for the little guy from taking excessive risk, has vowed to make markets free and fair for day-trading retail investors.
But the fact is that markets will never be fair for them, not in the way Warren wants. Institutional investors have more money and access to capital. Success in stock market speculation often comes down to who can afford to take more risk, and we can’t have the desired level playing field without enabling and encouraging small investors to regularly take enormous leveraged bets.
The GameStop saga is a missed opportunity to truly make markets more democratic. Democratizing finance, or getting more Americans invested in the stock market, is a laudable goal. Only about 50 percent of Americans are invested in the stock market. As the returns to capital outpace wage growth, this means that half the population is effectively shut out of America’s prosperity.
But accomplishing that goal starts with educating more people on risk and investing and expanding access to appropriate investments. Stock investing is risky, but there is a way to do it responsibly. The purpose of owning stock is earning higher returns and balancing that extra reward with some risk reduction. More Americans, even those with lower incomes, should arguably own more stock—not only because of the higher returns but because it does diversify their risk. Their assets consist mostly of their future earnings and one day Social Security benefits. Investing in stock means diversifying away from labor and low-risk government obligations.
In popular imagination, and in my high school finance class, good stock investing consists of picking those few stocks that turn out to be the next Apple or Google. But ideal stock investment consists of diversification among many stocks. For the overwhelming majority of people buying a simple index fund will bring higher returns and less risk than buying a few individual companies. Since end of January the S&P 500 is up 5.8 percent while GameStop is down more than 85 percent from its highs.
Robert C. Merton, a Nobel Prize winner in Economics and one of the fathers of modern financial theory, likens owing individual stocks to buying a single car part. It is expensive and useless, because its value inheres in how it contributes to a larger machine. The same is true for stocks: their value is based on how they contribute to your overall risk profile. A stock is more valuable if it is uncorrelated with the rest of your portfolio. When that’s the case it offers the potential for a higher return, while reducing your risk exposure. Investing is about balancing risk and reward, and research consistently shows index funds offer the best balance, and they do so for small fees.
The most disturbing aspect of the GameStop spectacle was not the hiccups at Robinhood or hedge fund managers whining on TV that this was all so unfair. It was the media and politicians, from Alexandria Ocasio-Cortez to Ted Cruz, cheering on small investors taking enormous risk that was almost certain to cost them money. If protecting small investors is truly their goal, our policymakers’ priority should be easier access to well-diversified, well-priced investments—not making day-trading easier.