I had an interesting conversation with my daughter on the way to school this morning.
We saw a family of deer strolling through our neighborhood and Emma blurted out, “I hate hunters!”
I’m not sure if she watched “Bambi” over the weekend, if one of her friends’ parents is a hunter, or what brought that to mind.
But it kicked off a great conversation!
We talked about the different roles that animals play in the wild, including predators and prey.
I told Emma about a story I read where the wolf population was taken out of a large national park and hunters were banned.
“Do you think this was good news for the deer community?”
Emma was surprised to realize that when there were no natural predators, the deer population became too large.
Many died of disease and malnutrition until the park brought back some wolves and established more balance.
Emma’s still not a fan of hunters. But at least she has a better understanding of the different roles that predators and prey have in the wild.
I bring up this conversation because today, we’re seeing a bit of a shift in the stock market and the roles that some investors play.
In particular, the drama with so-called “Reddit stocks” over the past few months has taken some key players out of the market in a way that could ultimately backfire on investors.
So today, I want to show you a startling statistic and explain what this means for your retirement savings.
Most importantly, we’ll cover some strategies for sidestepping the danger and making sure you keep your investments safe!
Short Sellers Are the “Predators” of Wall Street
If we draw a parallel between the deer conversation with Emma and today’s market, we would probably list “short sellers” as predators in the stock market.
A short seller is simply an investor who bets that the price of a stock will trade lower.
Technically, these traders borrow shares of stock from a broker and sell them at one price. They hope to buy the shares back at a lower price before giving the shares back to their broker.
For these trades, the short seller makes a profit when stocks trade lower. And the higher a stock price trades, the more money these short sellers lose!
You can probably see why these traders get a bad reputation with other investors.
After all, whenever traditional investors lose money in the market, chances are good that a few short sellers are smiling as their trades make money.
But while this may strike you as predatory or heartless, these Wall Street predators play an important role in the market’s ecosystem.
You see, whenever a short seller borrows shares and sells them in the market, they will eventually have to buy the shares back.
After all, the broker they borrowed the shares from typically charges interest for those shares and will need them back eventually.
So any time shares of a particular stock are sold short, we can be sure that at some point, these shares will be bought.
And the buying of those shares will help to stabilize the price of a stock and keep it from falling too far.
Short sellers can also help to send shares sharply higher.
Remember, short sellers lose money when stocks move up in price.
And if a stock trades high enough, the short seller will lose too much to hold on to the position and will eventually have to buy their shares back.
That’s exactly what we saw when shares of Gamestop shot higher earlier this year.
Running the Predators Out of the Park
So what happens when a cultural shift and social media channels on Reddit target short sellers and run them out of the market?
I’m concerned that without this important part of our financial ecosystem, we could be leaving certain areas of the market vulnerable to big risks.
And these risks could hurt unsuspecting investors who find themselves in the wrong place at the wrong time.
Take a look at the chart below, showing that short selling of stocks is now near historic lows.
Short sellers have essentially been run out of the market, partly due to social media channels on Reddit targeting stocks that have been heavily shorted and buying shares to drive the price higher.
It’s interesting to note that the last time short interest (the level of stock shares sold short) was this low, we had the dot-com crash that sent many speculative tech stocks sharply lower.
Could we be in for a similar situation in the weeks and months ahead?
It’s worth considering that without short sellers already committed to buying shares that they’ve borrowed, a selloff in the market’s most speculative stocks could wind up being even more damaging.
In fact, given the huge run-up in shares of companies that don’t even earn a profit (and some that don’t even have a viable product to sell to customers), it wouldn’t surprise me at all to see some big drops in the most speculative stocks.
And by running the short selling “predators” out of the market, we’ve essentially taken a motivated buyer out of the picture.
This could lead to a bigger drop in these names than we would have had if short sellers were more involved.
How to Protect Yourself If the Tide Turns
Fortunately for us here at Rich Retirement Letter, we don’t have to worry too much about a major pullback in speculative names.
That’s because we’ve been encouraging you to only take limited positions in these more volatile stocks.
It’s perfectly fine to take a small position in a company that may have a breakthrough technology (and may not have revenues or profits yet).
But you want the majority of your wealth invested in solid companies that generate reliable profits and pay lucrative dividends.
Keep in mind, these profit-generating companies are not the ones typically targeted by short sellers.
And they’re also not the ones that typically experience sharp drops when the market pulls back.
So by investing heavily in these foundational plays and speculating lightly in the market’s more exciting plays, you’ll be able to enjoy the best of both worlds.
This balanced approach lets you generate profits from some of the dynamic companies capturing investors’ attention during special growth periods like we enjoyed for the majority of the last 12 months.
And it also helps you sleep at night knowing that the majority of your wealth is protected regardless of how vulnerable these speculative areas of the market become.
Let’s continue to stay the course and build our wealth consistently so we can focus on the things that really matter in life!