Why the Wall Street David v Goliath story highlights the value of a good financial advisor
It’s been an exciting week. The activity in GameStop and the lessons people will likely learn afterwards, should highlight the value financial advisors bring to the table.
You know the story. A lower-priced stock, considered suitable as a short by some investors is run up to dizzying heights by a multitude of online individual investors. Some large hedge funds are forced to close out their positions. The “little guys” beat the “big guy”. It’s a David vs. Goliath story.
First, it’s OK not to feel too bad for the hedge funds. They would be considered “sophisticated investors”. They know the risk is unlimited. While a stock can decline to zero, it can rise to unlimited heights. “The sky is the limit.” Also, as another writer put it, “hedge fund” implies they hedge their investment risk. I would think they didn’t short just one stock, they likely shorted others too. They diversified, spreading the risk. They also know the Wall Street axiom “cut your losses early”.
Retail investors are a different story. Here’s what might have gone wrong for many investors.
Did they understand the risk they were assuming? A financial advisor would have explained it in detail.
Do they understand how margin works? If they bought $10,000 worth of stock with $5,000 worth of equity, a decline to $ 2,500 of equity would trigger a margin call. (50%, 25%. It can be higher, depending on the firm.) If the stock continued to decline, their equity could get wiped out, yet the investor is still responsible for the loan amount. An advisor would explain “you could lose it all.”
Did they click “Check here to accept terms and conditions?” They may have proceeded with something they didn’t fully understand, yet accepted the risks. “An advisor would explain the “what if’s” as they signed the papers.”
Under what circumstances does this chain of stores represent a good investment? By buying shares, you are becoming a part owner of the business. If someone else is shorting the stock, you are taking the opposite point of view. An advisor would ask: “What circumstances are needed for this investment to work out?”
Have they invested money they can’t afford to lose? You can imagine there were people who said “I’m all in” thinking it’s similar to playing poker. When playing poker in person, you aren’t seriously thinking about putting most of your life savings on the table.” An advisor would talk about safe money and play money. The investment pyramid, with it’s top 10% for riskier investments would come into the conversation.
Did anyone tell them it’s “a one way bet” or “you can’t lose?” We will likely never know. A financial advisor wouldn’t say that. Their compliance people would be at their desk in an instant.
When did “screwing someone” become an investment objective? It hasn’t. Financial advisors get clients focused on financial planning and longer-term goals. Clients might have “play money” but that should be money they can afford to lose.
Sellers require buyers. Paper profits are realized when you sell. The screen might show the stock is worth a lot, but you need to place a sell order and get an execution to close out your position. This means someone else needs to think this is a good time to be getting in, as you are getting out. An advisor would talk about taking money off the table. They would bring up rebalancing.
Where are the Compliance people? Red flags should be waved when it looks like investors are taking undue risk. An advisor’s compliance officer would be aware what was going on and starting to ask questions.
The bottom line is a financial advisor would (or should) be acting as a circuit breaker. A person can say “It’s my money.” They can take their money and business elsewhere. An advisor, with a long-term relationship in mind, would be asking the difficult questions. They would try to inject reality and common sense into the conversation.
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” can be found on Amazon.