Meme Stocks & Investment Risk: A Historical Perspective

The overnight success story has historically been a consistent dream as indicated through repeated financial bubbles. Whether it’s tulips in the Netherlands or Bitcoin in 2018 and 2021, people are always looking to change their life by taking on significant investment risk. The rise in popularity of meme stocks such as Gamestop is no surprise after looking back through financial history. These stocks are fraught with risk and wildly popular throughout social networks. If this desire for risk and reward is built into our lives, is it necessarily a bad thing to bet it all on black or “yolo” your savings on the newest GME? Of course, like countless other questions, the answer can be a bit more complicated than avoiding risk or dumping everything in an investment to moon.

Any basic finance course will teach you that risk should equal reward, and chasing greater returns is accompanied by assuming greater risk. However, increased risk is not necessarily a negative, as long as it is managed and the expected outcome fairly compensates for the risk taken. Life changing risk taking can yield immense results if your bet pays off, as evident in the story of Kiersten Crum, who:

“Amid financial desperation… took a leap of faith and started investing during one of the worst stock market downturns in history. In just over a year, Crum turned an initial $500 investment in Carnival Cruise Lines into an $80,000 portfolio and built a powerful personal brand as the ‘Stonk Queen,’ gaining nearly 200,000 followers on TikTok.” -CNBC

This domino effect of life changing events would not have been possible without Kiersten’s initial appetite for risk exceeding, or at least matching, the level of risk required to invest in a cruise company in the midst of a global pandemic. What to many seasoned investors may have looked like a bad bet turned out to be another meme stock rising to global fame.

The trouble arises when investors forget that risk can be a double edged sword. The same risk appetite that allowed Crum to amass a personal fortune ruined the fortune of Bill Hwang. The collapse and fallout of Archegos Capital encapsulates the other side of risk taking: what happens when it all blows up? After billions lost in risky leverage and swaps, the implosion reached further into credit institutions and according to Bloomberg:

“The worst thing is that it was an entirely preventable disaster made possible by Hwang’s lenders.” -Bloomberg

In this case, the desire for risk permeated between all of those involved, building a house of cards that eventually came crashing down. Credit Suisse bore the brunt of the fallout; however, any lender lacking the proper risk management in this situation could have been caught bagholding.

In the case of meme stocks, what causes individual investors to assume these massive amounts of risk? For typical investments this question is much easier as buyers seek to achieve their estimated return. With meme stocks there is the added nuance of group dynamics and social enthusiasm that can drive these asset prices to previously incomprehensible levels. When studying risk in group environments:

“The main finding that we learn from social psychology is that conformity, obedience and social perception are all tied to context and situation, much more powerfully than to character.” -SafetyRisk

In other words, seemingly rational individuals can make irrational decisions given different environments. Individual investors that may typically shy away from large amounts of risk can be swayed into accepting increasingly volatile opportunities.

The rise of meme stocks has coincided with large online communities discussing these prospects. While discussion has always been prevalent and equity research exists as a valid profession, receiving social bias in either a bullish or bearish direction can cloud the individual’s judgement. As these communities grow, its members can encounter the issue where:

“…the factors of Bystander Effect and Groupthink is so strong in large groups that it makes any sense of having properly assessed risk or any dependence on communication of risk highly unreliable.” -SafetyRisk

This unconscious bias should be one of the first to be identified when analyzing meme stocks. A group consensus of a buy “rating” is not necessarily a bad thing, but it should be something that is recognized. When these struggling companies’ stock prices are propped up by exploding demand, everybody wants to get their share; knowing what’s driving the growth can help determine when is the right time to get off the ride.

While social pressures can push people into riskier assets, there must be some driver creating this atmosphere of risk taking. Returning to less volatile assets shows this environment as a function of seeking return for assumed risk. As an investment, meme stocks inherit this characteristic as well. However, the motivations behind the search for these returns may have shifted in the individual investor. For many younger investors, facing and accepting this risk can be:

“a reflection of the current economic moment, where for so many people, mobility feels really out of reach.” -Vox

The overnight success story is a dream that is actually coming true for many people with the rise of meme stocks, and those who cannot see any way out of their current situation may gravitate towards these stories. After all, who wouldn’t wish they made the same investment decisions as Crum did with Carnival, especially when the pandemic put so many out of work. When the future is bleak, these stocks mooning can illuminate a way forward.

Though the risks have changed and these new meme stocks seem to be taking over the investment world, the old rules still apply. Taking on massive amounts of risk can be a great way to change your life overnight, while also being a great way to lose everything you’ve worked so hard to save. Planning and maintaining a balanced and diverse selection of investments can allow a portfolio to assume risk and weather volatility. This is especially important when trading in meme stocks since:

“Once a stock becomes a meme… it not only exhibits greater total risk, or volatility, but also greater correlation with US stock indices and with other meme stocks. In fact, once a stock achieves meme status, its correlation with other meme stocks jumps over 80%, according to our estimates.” -CFA Institute

This risk inherent to meme stocks is sought after by individual investors and can be properly managed. As a bet achieves meme status, understanding entry and exit points can be the difference between cashing out and blowing up another account.

Ultimately, balancing meme stock risk is a matter of understanding personal appetite for risk. Once that threshold is understood, acknowledging group risk bias and building a portfolio that properly balances that risk enables investors and traders to be involved in these equities in a method that allows for longer term profitability. Maintaining that discipline in trading plans and portfolio balancing can allow for the ability to stay alive in the market and be around for the next Gamestop, which may be just around the corner.