The rise of meme stocks: Four ways to help manage risk

Just when you thought the world couldn’t get any stranger, last January a vocal group of retail investors disrupted the markets, rallying behind a number of stocks and pushing prices up, as these investors like to say, to the moon. It was also the first time the words “meme stock” entered the investing lexicon, a term that refers to a stock that has climbed in value because of social media hype rather than traditional performance expectations. In this case, the hype began on Reddit, where members of one of the social network’s investing forums pushed a few stocks until their recommendations went viral.

As fun as it may have been to see the share prices of some seemingly random companies soar by more than 1,500% over two weeks, it was also alarming: Many who put money into these companies appeared to be simply following the crowd. With people becoming more comfortable using mobile-based investing platforms, and with COVID-19 stay-at-home orders contributing to an increase in trading, it may be easier to jump into a stock without thinking about how much you can lose. Indeed, many of those who bought in may have found themselves in the red when those stocks came back down to Earth.

That’s not to say purchasing an interesting stock is a bad idea, but at the same time, consider whether you want to put your savings at risk. Given how fast information travels today, meme stocks may be here to stay. With that in mind, we reached out to investing professionals from both TD Asset Management and TD Direct Investing, to ask what kinds of things investors may consider when managing their investment risk and making decisions in the face of so much social media-fueled hype.

1. Focus on fundamentals

Many successful investors suggest it can be wise to buy companies based on fundamentals and not on what a faceless person on the internet says. The idea is to have a thesis as to why you think the business might grow in value. For example, you can look at the company’s financials to ensure they’re not mired in debt, examine who’s in charge and feel comfortable they’re taking the business in the right direction, and more. “If you’re going to take your hard-earned money and invest it, I think it should be in a business that has sales, profits and cash flows,” says David Sykes, Managing Director and Head of Public Equities at TD Asset Management.

Sykes considers several things before investing in a company: Does it have some sort of competitive advantage? How about an expanding income stream? He also likes to see a strong balance sheet, which for him means little debt and strong, free cash flows — that is, cash the company generates after spending money on operations — as well as a growing dividend? That dividend is what a company pays to shareholders in quarterly or annual distributions. While investors can identify which fundamentals are important to them, Sykes says the decision to purchase should be rooted in something real. “It’s identifying a real business with real advantages,” he explains.

2. Stay diversified

One mistake many stock-chasing Redditors made in January? They put all their money in a single stock — or at least many said they did on the site’s investing forum. If they were telling the truth, they forgot a key tenet of careful investing: diversification, which means owning a variety of securities across various asset types, such as equities and bonds, and within numerous industries. If one stock does poorly, gains in other investments can balance out the losses, says Meagan Henriques, a Client Education Instructor at TD Direct Investing who leads webinars to help clients learn about investing.

That doesn’t mean you can’t choose to be a more active stock selector, but it’s important to consider portfolio diversification in such a way that if one stock doesn’t work out as anticipated, you can still help protect your savings. “When you’re choosing your investments, you may want to consider not being all in on the same sector or company,” she says. “You might have a portion that’s devoted to more volatile stocks, but you’ll have another portion that’s more stable. You can have some investments that could be gaining more than average, but you’re still managing your risks.”

3. Remain rooted in your comfort zone

Everyone has different risk levels — some are fine with holding more stocks, while others prefer putting more of their money in less volatile bonds. Even within equity markets there are different levels of risk. You may be perfectly OK putting money in an unproven small-cap stock that could fall to nearly zero, while your friend might only want to own shares in companies that are large and have consistent track records.

One way to determine your risk tolerance is to think about how much you can stomach losing. Does the idea of your portfolio falling by $500 make your stomach churn? What about $10,000? What if you lost those amounts over a week versus a year? Think carefully about what you can handle before you buy. “Figure out your goals, your time horizon and what you can tolerate,” suggests Henriques.

4. Plan your exit

If you’re putting money into individual stocks with the hopes of making a few dollars within a relatively short timeframe, it can make sense to think about when you should sell, says Henriques. If your thesis proves right and the share price climbs, will you be happy to make a 5% return? Do you think the stock could climb further and earn you 20%? The same goes for the downside. “When a stock goes up, people tend to get greedy and think it can go higher, and when it goes down we get scared and want to sell before we lose more,” says Henriques. “If you’re buying something that’s more volatile, you have to set parameters beforehand and decide when you’ll sell.”

Whichever stocks are on your radar — whether they’re stay-the-course stocks or short-term plays — you should consider approaching all of your investing in the same way: Have a good idea that you think will make you money during your time horizon. “My number one rule is don’t lose money,” says Sykes about his approach. “If you want to be more active and take a view on a company or a sector, then you may need to take on more risk. But don’t get in saying you’re going to lose.”