Meme Stocks Explained
Until very recently, the idea of getting advice on investing from social media, let alone from a social networking forum like Reddit, probably seemed absurd. Trusting virtual strangers to help you navigate the latest stock market fad is the exact opposite of a sound investing strategy. Anyone watching the markets closely at the beginning of the year, however, saw that some stock prices “mooned” overnight, and it wasn’t because the companies had made unexpected changes to their business models. All of a sudden “meme stocks” were everywhere, even showing up on every news outlet.
What Are Meme Stocks?
A meme stock is best described as a stock that has gone viral and has attracted widespread attention from retail investors. The attention these stocks are receiving is usually based more on hype than on the company’s actual valuation or performance. The value of these stocks rises due to excitement started by people in forums on sites like Reddit.
You’ll most likely remember some of the meme stocks that trended and increased in value this year. It was hard to escape the discussions about them. These stocks included Blackberry, AMC Theatres and GameStop. Even Tesla has achieved meme stock status due to the attention it received in the Reddit retail investor message boards.1
What About Risk?
The CFA Institute defines a meme stock as a stock that has gained notoriety on Reddit’s WallstreetBets discussion board.1 Once a stock receives enough attention that it crosses a certain threshold, the CFA Institute keeps track of the date and starts to track information about the stock and its performance.1
While it all seems very exciting, the volatility makes meme stocks a questionable investment. The average volatility of these stocks prior to becoming memes (“pre-meme”) was 83%.1 Depending on your particular risk tolerance and goals, these stocks may be much too risky for the average investor. Once these stocks reached meme status (“post-meme”), their volatility jumped to an average of 106%.1
The Meme Stock Cycle
Unlike a long-term investment strategy, meme stocks operate on a much more volatile cycle. Meme stocks all tend to follow a similar pattern:
- Early Adoption
- Rise in Popularity
- FOMO
- Profit-Taking
Early Adoption
In this initial phase, a few investors identify a certain stock they believe is undervalued. These investors begin buying the stock in large quantities. Early adopters usually are the ones who benefit most from investing in a meme stock.
Rise in Popularity
As the early adopters begin buying large amounts of the stock, more people take notice and begin paying attention. The stock price begins to rise.
FOMO
As word spreads, the stock goes “viral” across the Internet and social media. More and more retail investors join in the buying frenzy, driving the stock price up further. FOMO stands for “fear of missing out.” At this point, many retail investors are jumping into the mix when stock prices are already very high.
Profit-Taking
Quickly, often after only a few days, buying peaks and the early adopters begin cashing in on their gains. This starts a chain reaction, which drives stock prices back down.
Key Takeaways
It sounds scary but it isn’t all bad. One positive aspect of the recent meme stock fervor is that it brought investing into mainstream conversation. Now more than ever before, people are discussing the stock market and taking the time to educate themselves about investing.
If you’re thinking about jumping into the next trending stock, tread carefully and consider talking to your investment advisor first. While it is exciting to think about, studies have shown that even the most experienced day traders lose money when they invest. Novice investors who were allowed to buy stocks on margin may have found themselves losing money, or even worse, owing money, if they miscalculated the right time to sell.
In most cases, it’s more beneficial to focus on long term financial goals than to get caught up in short-lived investment trends. Rather than searching for the next hot stock, consider your risk tolerance, time horizon and financial goals. Work with your trusted financial professional to determine if investing in a meme stock is the right move for you, or if you are better off sticking to your long-term investing strategy that should be able to weather normal market volatility.