Latest Economic Review: Sunpointe Illuminations

risk financial management

To the Moon & Back: A behavioral finance perspective on the GameStop Mania

Over the past few weeks, members of an online investing group called WallStreetBets, part of a website called Reddit, banded together to “squeeze” short-sellers of struggling companies such as AMC, Nokia, BlackBerry, Bed Bath, and Beyond, and most notably GameStop.  Because big holders of these stocks (the short-sellers) had to cover their short positions in a panic situation, they lost billions.  During the rise in these stocks, some investors tried to “ride the wave” to make easy money.  Unfortunately, the stock prices for these companies have come crashing down in recent days.  For example, the price of GameStop started at around $20 per share and rose to nearly $500 per share at its peak last week.  If you thought the stock was going to $1000 and you bought it at $450 you have lost a lot of money.  As of February 10, 2021, the stock is at approximately $50.

From a behavioral finance perspective, what you have here is a classic “speculative mania.” In my book “Behavioral Finance and Wealth Management”, I review famous early examples such as the Dutch Tulip Mania of the 1600s.   Speculative manias are characterized by the rise in the price of an asset that has no connection to fundamental reality.  The mania spreads as more people hear about it, an ever-growing number join in fear of missing out on some quick gains. This type of feedback loop pushes the bubble even higher (especially when short sellers have to cover their positions) and prices reach crazy levels. Inevitably, many people “buy high” just as the mania climaxes.  In the case of GameStop, once the initial squeeze started the stock price rising, the moniker of a ‘meme’ stock took hold – which happens when a “social contagion” carried forward by sites such as Reddit, occurs.  As the “meme” spreads, people act like a herd of charging bulls (a bias known as “herding”). Crowds are driven by a fear of missing the ride – or, in-wall street parlance, fear of missing out (FOMO).  When FOMO enters the picture, even rational investors cast aside their normal discipline.

There are several ways to handle this type of situation.  If a rational investor likes to participate in a GameStop situation (akin to gambling), then I often suggest carving out a “mad money” account.  Keep 95%+ of your assets invested prudently.  If you must, “gamble” with only a small portion of your asset base.  This should keep you on track to reaching your financial goals without jeopardizing your long-term wealth.