Studying historical events in the stock market can be a great way to improve one's own financial process. Indeed, it is a lot easier and less painful to learn how not to lose money by reviewing the actions of others rather than losing money yourself. With so many fresh examples from the past couple of years, it is difficult to know where to begin.
Too much borrowing
Over the past two years, there have been some very high-profile disasters in the hedge fund world, which have not only floored the hedge funds themselves but also sent significant shockwaves across the financial sector.
Archegos Capital Management and Melvin Capital have both had to take massive losses over the past two years due to taking on extreme amounts of leverage in periods of high market volatility.
Of these two hedge fund firms, Melvin is the only one still alive. After a substantial outside capital investment, the fund met its liabilities and continued trading. Archegos was not so lucky. When it collapsed, many Wall Street banks were left with huge holes in their pockets, and no one wanted to bail it out.
The common factor linking these two collapses is leverage. Both funds used a lot of leverage to increase their exposure to the market. This worked very well when the market was moving in their favor. However, when the market started to turn, the strategy quickly unwound.
Neither of the entities had any control over the events that led to losses. Melvin's positions were targeted by groups of online investors aiming to make bank by squeezing out short-sellers, which it had not anticipated. This would have been manageable if the hedge fund had not been borrowing so much money. Archegos faced a similar situation, except it also exposed several large investment banks in its leverage schemes, which understandably started dumping their exposure to the fund in order to limit their own losses once the jig was up. As Wall Street gave up on the firm, it lost control of its destiny.
Sentiment changes
Away from these implosions, there have been some disasters in recent years that have not involved leverage, but were instead related to overinflated expectations. WeWork (WE, Financial), for instance, has seen its valuation collapse by around 90% from its private market high. The value of the business has collapsed because investor confidence has evaporated, and investor confidence was the only thing supporting its prior high valuation.
The company always had problems. It was heavily loss-making, had corporate governance issues and a shaky business model. Still, as long as investors were willing to pay a premium to be involved with the company's hyped-up growth outlook, it could shrug off the questions about its operating performance. When confidence evaporated, there was nothing for investors to hold on to. The firm became impossible to value without profits, and its market value plunged.
This is not the only scenario where evaporating market confidence has led to a substantial share price decline over the past couple of years. Other examples are UBER (UBER, Financial), Peleton (PTON, Financial) and Lemonade (LMND, Financial).
Takeaways
These are only two examples of market disastsers over the past couple of years, but they do provide some valuable case studies investors can use to develop their own process.
Using leverage to increase returns as an investor is a strategy that can work. However, when an investor starts to borrow money, they also give up a certain level of control over their portfolio. In doing so, the chances of a significant event materializing that can lead to large losses significantly increase. With leverage, you can also lose more money than you invested in the first place.
At the same time, these lessons show how important it is to pay attention to valuation. If one is going to invest in an unprofitable business, one has to rely on market sentiment to keep the share price supported. Sentiment can be incredibly fickle and unpredictable. Equity market traders try and ride market sentiment to make money in the market. This strategy can work, but it is vital that investors do not confuse sentiment trading with long-term investing. Sentiment can change quickly, and investors can be caught off guard if they are not aware.
These are not the only lessons of the past two years. Still, in my opinion, they are some of the most valuable.
