Meme Stocks and Speculation Are Back on the Rise

June 15, 2021

"There is nothing in this world which will so violently distort a man´s judgment, more than - the sight of his neighbor getting rich." – J.P. Morgan, 1907

As cryptos have plunged, stocks like AMC, GameStop, and Clover Health, also known as the meme stocks, have been surging.

With retail trading now accounting for almost as much volume in financial markets as mutual funds and hedge funds combined, speculative momentum is running much hotter. Looking at what is going on through a historical lens, this type of speculation was very popular in the late 1920s right before the Black Tuesday stock market crash which led to the Great Depression, and during the late 1990s right before the Dotcom Crash. Speculation in markets is nothing new, but this might lead to the thinking that the speculation we’re seeing now is foreshadowing an inevitable market crash. While that timeline is possible, the current wave of speculation is a little different because it has been mainly relegated to specific pockets of the market, rather than the overall market. Over the past year, meme stocks have significantly outpaced broader stock market indexes.

A lot of this speculation has spread throughout social media and much of the deeper discussion is done on Reddit’s Wallstreetbets community. When you see the potential gains that could be made, joining in on the speculative investing craze starts to look pretty attractive, but there are risks. One poster on Reddit showed that they made almost a 3,000% return in three months, turning $6,000 into over $192,000.

But then there’s the other side. A different poster made a post about how their mistimed bet resulted in a 74% loss over one week, evaporating over $1 million of their invested assets.

The way we are programmed to think when getting involved in something like this is that we often over emphasize the upside potential and under emphasize the downside potential. If that wasn’t the case, casinos wouldn’t have any business. Every casino game has odds that favor the casino. Over time, the casino will win much more than it loses. Therefore, any rational participant wouldn’t go to the casino hoping to make any money, but the millions of people that gamble at casinos every year with the hopes of hitting it big show that we tend to be more irrational than we give ourselves credit for.

With investing, it works the other way around. The odds favor investors over the long-term. The lowest annual return over a 20-year period for the S&P 500 is about 6%. That doesn’t mean we won’t see lower returns than that in the future, but if we use history as a guide, we can be pretty confident that a long-term investment strategy will pay off.

From an overview, speculating in meme stocks is essentially reducing the odds of making a positive return to somewhere in the realm of 50/50. You are also ramping up your potential gain and your potential loss. You likely have better odds of making money than at the casino, but they won’t be a whole lot higher. This should really be considered gambling, then. Gambling isn’t necessarily a bad thing to do, you just need to be aware of its limitations. Using money that would impact your standard of living if you lost it to buy meme stocks is what we would call financially irresponsible, but if you have a sum of money that you want to spend on entertainment, it’s completely fine to use that money gambling on meme stocks, being aware that it’s entirely possible to lose the majority of your principal. The main thing to be aware of is that this is not a sustainable long-term strategy. Getting more into the weeds, right now meme stocks are extremely decoupled from fundamental stock valuation metrics. Stocks rarely remain decoupled from their fundamental, underlying value. Either the price has to go down, or the business has to improve significantly. Almost no one believes the businesses of the meme stocks will improve enough to justify their price. That means a lot of what's driving their prices higher or lower is mostly investor sentiment. When a stock is trading based on sentiment, you're looking at something that's a zero-sum game. You'll see a lot of winners, but you'll also see a lot of losers. No matter how smart you are, everyone gets caught on the wrong side of the trade from time to time. Properly managing risk so that you don’t get wiped out when that happens and being aware of the purpose of your invested money, therefore, is incredibly import and should determine whether you should have anything to do with meme stocks at all.

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