When Investing Becomes a Casino

2020 was a tragic year for those who fell victim to Covid-19. Hundreds of thousands globally lost their lives while millions more lost their livelihoods. Few parts of the world escaped its grip; Bali has been among the worst affected and the misery is not yet over.

Yet some have benefitted. Industries and businesses that have been able to adapt to a locked-down world have made small fortunes. Most billionaires have also become richer during the pandemic, mainly due to their owning companies or shares that have soared in the unexpected stock market boom.

Not all companies and shares have risen of course. Those connected to tourism and hospitality have suffered immensely. So have shopping malls, high street stores and entertainment. But online sales of just about every commodity have boomed. And the big winners have been in the technology sector, whose shares have been the driving force in the stock markets, particularly the US market which has dominated the globe, despite the country’s terrible record in handling the pandemic and despite the chaotic politics.


The long and short of it

One of the techniques to make money in the stock markets is to actually bet against companies and shares that are likely to fall. This is achieved by ‘shorting’ the shares, and is perfectly legal. Many ordinary investors hold hedge funds that indulge in the practice. It works by ‘borrowing’ (for a fee) shares in the target company. They then sell the shares on the understanding that they must buy them back and return them to the original owner. If the hedge fund’s analysis is correct and the shares fall in value they then buy them back at the lower price and pocket the difference when they return them to the original owners.

The practice could in fact benefit all parties, except of course the company whose shares are being betted against. The original owner of the shares may intend holding them as part of a long term strategy and is quite happy to earn a fee by lending them out for a while. Meanwhile, the transaction makes a profit for the borrower (the hedge fund) and investors in the hedge fund share the profits.

A ‘long-short’ fund will invest conventionally in shares which it thinks will rise while at the same time will ‘short’ shares which it thinks will fall. A typical hedge fund I was looking at for example had invested conventionally in technology companies and gone ‘short’ on airlines and cinemas. It returned a profit of over 40% in 2020, a better return for an investor than leaving money in the bank at zero interest.

It seems a bit of a no-brainer but it’s not always that easy to determine which shares will rise and which will fall. Should the hedge fund manager get it wrong, he could lose money on the ‘long’ shares and much worse, have to pay more money to buy shares back and return them to the lender of the ‘shorted’ shares. The loss would be added to the cost of the fee for borrowing the shares. In a worst case scenario the fund could be wiped out and investors would lose all their money. So be aware of this risk if you are considering a long-short fund.


Revenge of the small guys

While the practice of ‘shorting’ is widely accepted, it can also be damaging to companies that are targeted when it gets too aggressive. But it can make a lot of money for hedge funds and their managers who exploit weaknesses, such as companies suffering from the pandemic, even though it seems unfair that some people should benefit from the misery of others. Last month a large number of ordinary retail investors, dominated no doubt by Millennials, got together on a social media channel and agreed to invest heavily in a high street video gaming company, Game-Stop, that was in trouble and being targeted for ‘shorting’ by hedge funds. The share price was only $20 and due to falling high street sales looked like falling further. But as a result of thousands of people buying the shares the price rocketed within days to $492 a share. So the hedge funds had to jump ship while they could and pay a huge price to repurchase the shares they had borrowed. Hedge funds lost billions of dollars and not surprisingly cried ‘foul’. But are they not guilty of manipulating the market themselves?


What are the lessons for ordinary investors?

First of all think twice about supporting a similar social media campaign. The Game-Stop action achieved its objective but the risk of losing money is still high since inflated share prices eventually fall to reflect a more realistic value.

Don’t be put off from investing by events that hit the headlines, but don’t follow trends that suggest there is easy money to be made. Bitcoin and other cybercurrencies are examples of high-risk, unregulated investments where you might be lucky but also run the risk of huge losses.

Last year was a record year for sales of retail investment funds. No surprise really since the stock markets were really the only place you could make a good profit. Bank deposits and government bonds are safe but pay close to zero real returns. Many mutual funds returned between 20% and 60% last year, mainly in areas of technology and sustainability. They may do the same this year but don’t count on it. If you have suffered losses business-wise or job-wise due to the pandemic it is very tempting to pour any remaining money into the stock markets. It may pay off but after such a strong run, there is bound to be a correction at some point. This is not a problem if you are looking long-term because markets eventually bounce back after a crash, but if you are hoping to make a quick buck or two to help you out in the short term it is highly risky.

Whether you are putting your money into setting up a small business or simply buying shares or mutual funds, you must do so with a view to building up wealth in the long term. There is no safe or guaranteed way to make money quickly. If there was we would all be rich and I wouldn’t be writing this column!


Colin Bloodworth, Chartered Member of the Chartered Institute for Securities and Investment (UK), has spent over 20 years in Indonesia. He is based in Jakarta but visits Bali regularly in normal times! If you have any questions on this article or related topics or would like to receive a free monthly newsletter on financial matters you can contact him at colin.bloodworth@ppi-advisory.com 


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Copyright © 2021 Colin Bloodworth