Why Pump & Dumps Are Dangerous

On Sunday evening, before GameStop had fallen 85% from its peak, I said:

My guess is GME will collapse in the coming months or year when this charade passes and a lot of people will get hurt along the way.

I can’t lie. I am really mad to be right about this. Mainly because all of the narratives surrounding this whole charade have been so disingenuous/misinformed and a lot of famous people promoted those bad narratives along the way. And now we’re finding out that a lot of small retail investors are left holding the bag. In fact, we’re finding out that hedge funds made a lot of money at the cost of retail investors. So, what happened here? How can we try to avoid this again in the future?

One of the worst narratives that started this whole thing had to do with how short sellers are bad. The basic story was, “short sellers manipulate companies lower than they otherwise should be and hurt firms and their employees”. That sounds bad. Except, as I explained previously, the mechanics of short selling also create buyers. There’s nothing inherently good about buying or selling stocks. So, the key question has to be, does short selling drive stocks below their intrinsic value? No one can be certain about the intrinsic value of a stock, but one thing we do know is that short sellers have never ruined a great company. After all, this is like believing that a person betting against a horse at the track can meaningfully make the horse run slower by placing a bet that the horse and rider don’t even know about. It just doesn’t make sense. For the most part, secondary markets don’t directly influence the firms and their operations. So, it would be extremely difficult for short sellers to kill a business. Further, the academic research on this matter is pretty black and white – prices are actually less efficient when short sellers are less involved in pricing securities.

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William K. 4 weeks ago Member's comment

Thanks for the analysis, which makes perfect sense. And I can certainly agree that sometimes it is painful to be correct, when predicting pain and damage.

I looked at the rapid rise and immediately saw that the only way to get rich would be to sell, and that in order to sell, there must be buyers. That part of the stock market is quite easy to understand, even for those lacking experience. The time to sell would be around the curve's first inflection point. Not the most possible profit, but the surest profit point.

The expression "Pump and Dump" is new to me, but it makes perfect sense as a description of what happened. So will an investigation reveal anything that was against the rules? Probably not, but certainly there is a small of something in the air.