The Dirty Secret about Melvin Capital, Reddit, and GameStop

Before garnering infamy for getting crushed by self-proclaimed diamond-handed apes, Melvin Capital was famous in the industry as one of the top-performing hedge funds. From its inception in 2014 through the end of 2020, the fund returned an average of 30% per year. In January, it plummeted 53% and required a bailout from two other hedge funds. There are countless angles to this incredible story, a popular one being, “successful hedge fund upended by a completely unforeseeable risk — an army of Redditors.”

This angle isn’t necessarily incorrect, but it overlooks a crucial piece of information — that’s how risk works.

Like a tiger crouched in high grass, it is always lurking, unseen, ready to strike. You don’t return 30% for five years without taking some big risks. And as impressive as those returns were, the risk was always there. Using leverage, options, short selling, and having extremely concentrated positions are all strategies that can juice your returns when they work but can be devastating when they don’t. This wasn’t the case of five great years and one unlucky month. This was a risky strategy the entire time, with risk suddenly materializing and cutting Melvin’s fund in half in the blink of an eye.

You may be thinking to yourself, “c’mon, nobody could’ve predicted the WallStreetBets/GameStop phenomenon. That risk was impossible to anticipate.”

Again — that’s how risk works.

Each January, Barron’s gathers the top experts on Wall Street for a roundtable discussion. Legendary investors and economists take stock of the current environment and offer their thoughtful expectations for the upcoming year. One of my favorite annual traditions is reading the roundtable discussion from the prior year. As bright as the panelists are, they are pitiful prognosticators. It would be easy to comb through the discussion and pick out some of the worst predictions, but I’ll just stop at the headline from January 2020: There’s Almost No Chance of a Recession This Year, Experts Say.

Oops!

The panelists mentioned risks spanning from high stock market valuations, Federal Reserve policy, an escalating trade war with China, conflicts with North Korea and Iran, climate change, the presidential election, and inflation. Not a single mention of the potential for a once-in-a-century pandemic.

I don’t want to be too hard on these folks, as Yogi Berra said, “it’s tough to make predictions, especially about the future.” The point is, the biggest risks, the ones that have the greatest impact, are those that catch us by surprise. Said differently, by Carl Richards, “Risk is what’s left when you think you’ve thought of everything else.”

Luckily for investors, diversification is the protective shield from catastrophic risk. Saving what you can into a portfolio of low-cost index funds and being patient for a couple of decades is almost every person’s greatest chance of accumulating wealth. It won’t get you 30% annualized returns, but you’ll likely avoid the catastrophic risks, which is what matters. Surviving the short run is required to thrive in the long run.

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