Is borrowing and lending bad? Like anything else, a full answer isn’t always so straight forward. There are plenty of situations when lending and borrowing is perfectly acceptable. We all want to be good neighbors, be charitable, and provide a system that allows society to function smoothly. It is nice to lend. Especially if you have the luxury of not expecting or needing repayment. It is also nice at times to borrow and allow others to lend. By leaning on a friend or neighbor, you can invite them to be charitable – then you are able to repay them and thank them.
“The wicked borrows and does not pay back,
But the righteous is gracious and gives.
Psalm 37:21
Note that this verse does not end at “The wicked borrows.” Borrowing is not all bad. What would be wrong is to borrow, and not be able to pay back. As Proverbs describes this situation, “The borrower is slave to the lender“.
Borrowing Stocks
This past week, borrowing made major headlines in financial news. If you haven’t heard, here is a great summary by Paula from the Afford Anything podcast.
Short Selling
Imagine a guy named Joe. While Joe’s friend Pete is on vacation, Pete lets Joe borrow his car valued at $10,000. Pete isn’t using it this month, so why not? Joe even tells Pete that, for letting him borrow it, he’ll leave a full tank and a tip when he gets back. Sounds like a good agreement.
Once Joe gets the keys, he sells the car for $10,000 cash. Why? Well, because Joe has a hunch that the value of that car is about to go way down while Pete is away on vacation. Joe plans to repurchase the car once the price is $6,000, then he can return Pete’s car plus tip no questions asked at the end of the month – thus securing $4,000 for himself. After all, Pete gets his same car back, plus tip. No harm, no foul right?
What I described here is an example of what is called short selling when done with company stocks. This is a strategy used by investors, often institutional investors like hedge funds, to bet against companies that they think will fail. Investors borrow stocks from brokerages, sell them, repurchase, and return pocketing the difference.
The Problem with Short Selling
So what is wrong with this story of Joe and Pete? Well, although Joe has the intention of repaying Pete in his plan, he is actually creating a situation where he is a borrower that may not be able to fulfill his promise.
Imagine, Pete leaves for his vacation. Joe sells that car and has $10,000 cash. The next day, a story breaks out that this model car was the Pope’s favorite! Everyone wants one! Every dealer has run out of this model and with the recent demand, they’re now worth $20,000. How would it feel to know that Pete is coming back and wants his car. Joe doesn’t have the extra 10k to get the car back which puts him in an extremely uncomfortable situation. Now, the borrower is slave to the lender, and Joe is unable to repay his friend.
Buying vs. Betting on Stocks
When I buy a share of a company, I can picture it as a physical good. I pay $X and own a small fraction of this company. In this case, the risk is capped at $X. If the value of that physical company goes to $0, I have lost everything, but at least they can’t take away more than what I purchased. This is the same as buying anything else. I can buy a car, and in the worst case it breaks down or gets totaled and I am out my money. Oh well.
Buying stocks has a capped risk which protects the investor to an extent. It also has an unlimited potential return. Although it is uncommon, the value of that company could pretty well skyrocket to any value that the world decides it is worth.
When you short sell a stock you are doing the opposite of buying. Your reward is capped at $X value of that stock. Meanwhile, your risk is unlimited. Your risk becomes whatever the world thinks that stock should be priced at.
Even worse, if someone finds out that all of the shares of the company are on loan and need to be returned, they know that eventually the borrowers are going to have to buy them back. This makes those shares even more valuable now, because someone needs them – although not out of any good that the company did. These shares are desired only because someone has borrowed and sold, and now they have made themselves slaves to whomever owns them.
In summary short selling is a bet, yet unlike throwing all your money on black or red, it is worse because there is no limit to what you could owe back.
GameStop
This is exactly what happened this past week with GameStop stock. Some guys on the internet found out that Big-Time-Investor Joe’s had borrowed and sold millions of shares of the company (I heard close to 85% worth), and now they owed those shares back to Banker Petes.
The little man decided, “Well, that makes these shares a little more valuable now that all those Joes need to buy back 85% of the company! What if we own them all and they need to come buy them from us?”
And they snagged them… forcing the price to skyrocket to (dare I say the adjective of the century…) unprecedented levels in just days! Now, it has been a rollercoaster ever since. Look at the screenshot below from Google. This is showing that within the past year, one share of this stock has been considered to be worth anywhere from $2.57 to $483!
This is a rollercoaster that I would not want to be on or near, because it is going to crash*!
Could you imagine, if someone borrowed 1,000 shares for $2,570 then owed back $483,000 plus interest?! I do have a few thousand to lose, but I do not have half a million to pay back if something goes wrong!
My Thoughts on GameStop
Every investor should be an informed consumer. Whether someone is investing on your behalf, you only have money in a company 401k, or if you are doing it on your own, you need to know your potential risks and rewards. We don’t need to be afraid of risk, but we do need to respect it. I had a boss who would say, “We are risk tolerant not risk adverse.”
Like every aspect of our life, where we invest our money should be examined.
Little investors (retail investors like you and I) should know that picking individual stocks can and is a gamble, and you should only gamble what you are willing to lose. Meanwhile, not investing at all is also a costly risk. This is why many are turning to index funds to utilize the efficiency of the markets while having relief from (some of) the crazy ups and downs.
Big investors (institutional investors) even more so, should know that when you have a hedge fund that is trying to beat the markets, you are attempting to do what no one (or very few people) can do. Although they have gotten away with sneaky investing strategies in the past, they are fully responsible to be aware of the society that we live in, in which an online community of investors (just as much as mainstream news outlets) can convince a whole bunch of people that a fading company has a lot of value. These are the companies that always say, “Past performance does not guarantee future results“, but now they are upset that their past strategies of shorting stocks will no longer work because the internet called them out on it. These funds knowingly placed a bet that they knew had infinite risk while trying to get an edge, and they failed. We can’t feel bad for that. You can only hope that they are more aware of modern risks, like social media, in the future.
In the end, the people I do feel bad for is anyone who was unknowing or uneducated in the area, and they put their trust into someone by hiring them to do these bets with their money. Anyone who had a fund that they did not know had these short sells in them, that is too bad. This is all the more reason to be an aware and examined consumer in all areas of consumption.
This is also the reason that I prefer a DIY approach to investing. If I screw up, I would rather learn from what I did myself than be tempted to blame someone else.
Awareness is Good, Markets are Crazy
Lending and letting others lend is good, at times. It is bad to put yourself in a situation where you would be unable to repay what you borrow. Consumer credit, high interest car loans, or straight up gambling are all ways that borrowing could be abused if we are not aware. If borrowing, have a plan for repayment; otherwise, like Joe or many of these hedge funds lately, you could end up with some uncomfortable explaining to do.
Be charitable, lend to others and ask your friends to lend to you. This creates a good community.
I’ll be following along with all of the GameStop/memestock craziness because it is facinating and historic, but I pray for any innocent investors caught in the crossfire of this GameStop craziness. Knowing where and how your money is invested is important.
*Update as of 9:30 AM on 2/2/21
It looks like the rollercoaster has reached the peak and is in the process of falling very fast.
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