Did you jump into meme stocks this year? You likely weren’t alone. Thousands of new investors, with time on their hands, discovered the excitement of speculative stock trading. In a very short timeframe, companies with no earnings and uncertain prospects skyrocketed to unseen heights. For many, it presented a too-good-to-resist money-making opportunity.
A major catalyst for these big moves? Online communities such as Reddit, which attract a wide following of investors looking for stock tips. One particular subreddit, WallStreetBets, grew in popularity with an entertaining mix of commenters touting aggressive trading strategies and sometimes profane market lingo. It built an audience of more than 10 million followers — and that’s a lot of influence. When those followers started buying recommended stocks, even in small amounts, they created a mania for previously unloved companies.
With the surge of buyers, several stocks saw a sharp rise, followed by an almost equally swift retreat to lower prices. The party only hit pause when several brokerage firms suspended and then temporarily limited daily trading volumes on these volatile companies. And just like a car re-accelerating after a stop, it was harder for traders in these stocks to put the pedal to the metal after being required to slow down.
Many investors can see now that meme stocks were a mania. A craze. A fad. Not the first, and certainly not the last. Manias are typified by excessive enthusiasm that often defy reason. Where investors can get themselves in trouble is when they might take a bigger risk than they would normally consider. Let’s look at how to spot an investing mania, and what you can do to protect yourself.
A bit of (flowery) background
Meme mania follows a long history of collective enthusiasm for investments with prices rising beyond any reasonable value of the underlying asset. As far back as the 1630s, during what’s known as the Dutch Golden Age, investors in the Netherlands pushed the price of tulip bulbs (newly introduced from Turkey) into the stratosphere. At one point — notably before the bubble burst — a single bulb of the spring-blooming perennial was valued at more than the cost of a home. A century later came the South Sea Bubble, when the South Seas Company was given a monopoly by Great Britain to trade in the southern hemisphere — and people believed riches were assured. (Spoiler: They were not.) In more recent history, the Dot-Com Bubble saw the NASDAQ Composite Index rise about 500% between 1995 and 2000. When that bubble burst, the index fell 75%, wiping out most of the previous gains. In each of these cases, many investors appeared to be making a lot of money, until they were not.
What sparked all the excitement for meme stocks?
Time and money fed the frenzy. During the course of 2020, the COVID-19 pandemic created a radical shift: Without a work commute, people confined to home found they had more free time during the day. At the same time, there were fewer opportunities for discretionary spending. No one was going out for dinner or spending money on live entertainment. According to the Conference Board of Canada, Canadians saved almost 15% of their income last year. That works out to an average of $5,500 per person in extra money. With cash in their sweatpants and time on their hands, new investors had wiggle room to jump into the stock market.
What drives a mania in the first place?
Two factors typically drive manias: A lack of skepticism and a fear of missing out (FOMO). In his article “What Inflates Investment Manias?” psychologist Nigel Barber points to a lack of skepticism as a key characteristic of all manias. In other words, those caught up in investment bubbles consider only the possibility of gain. The direction their investment will go is up!
It’s not just those who are new to investing who get caught up in manias. History has many examples of highly intelligent people losing money in the mania of their day. Even Isaac Newton — the guy who developed the theory of gravity — lost a fortune by participating in the South Sea Bubble.
“If a genius like Isaac Newton can get caught up in fraudulent investments, so can anyone,” Barber says. “The irony is that investors, as a group, are wealthier, and better educated, than average.” People caught up in manias appear to be comfortable investing in hot securities with virtually no knowledge of what they are buying. Their confidence is guided by the fact the market price is rising. It is only after the bubble bursts that investors re-assess the lack of scrutiny in their decision-making process.
Manias may be sustained by a self-perpetuating cycle: People buy an asset because the price is rising, and that drives the price even higher, which in turn creates more demand because people don’t want to miss out. While FOMO may feel like a modern phenomenon, we can thank our prehistoric ancestors: The ability to survive a sabre-toothed tiger attack was dependent on being part of a group. Today, we are still hardwired for this safety mechanism, but now it directs us to want to be where the cool kids are.
How do I override my prehistoric brain?
When you are thinking about buying a speculative stock, it can be wise to take a breath and then ask all the questions you would want answered on any investment that goes into your portfolio. By establishing a simple checklist of the things you need to know as a prudent investor, you may be in a better position to avoid getting caught up in the next investment mania.
Before considering any potential investment, consider a gut check: How comfortable are you with the risk of losing an investment? How would you take a $500 loss? Or a $5,000 one? There is really no right or wrong answer — but it is crucial that you understand your risk tolerance before you plunk your money down.
Next, you could ask these three questions about every investment you consider.
1. Do I understand the fundamentals?
This means looking at what a company does. For example, does it build widgets, like smart phones, or provide a service, such as an airline? Is the business profitable? What are the prospects for the company and the industry? Making time to consider the fundamentals of any investment may help you build the knowledge that will help you to avoid the trap of a lack of skepticism. In many cases you may be able to find what you need inside your discount brokerage. TD Direct Investing’s platform, for instance, lists all kinds of fundamental data you can use to make investment decisions, including research from analysts.
If fundamental analysis is not something you have either the time or inclination to do, investing in equities may still be accomplished by considering ETFs and mutual funds.
2. Is the investment different enough from my other holdings?
When a stock looks like it’s headed to the moon, speculators have a tendency to go all-in, putting all of their money in one stock. While that may be fun to do at the casino, it shouldn’t be confused with an investment plan, which typically requires some level of diversification. By holding a variety of investments that react to changing market events in different ways, investors may help insulate their portfolios from a nasty shock. Anna Castro, a Portfolio Manager at TD Asset Management Inc., puts it this way: “A mixture of investments in your portfolio supports your financial wellbeing the way a varied diet helps keep you healthy.”
3. What is my goal with this investment?
If you are comfortable as an active trader, there may be nothing wrong with purchasing stocks to hold for a short time period, but you may consider being clear about your investment objective before you make any purchase. Castro points out that “Your time horizon, risk appetite and financial objectives are based on your personal situation, not your neighbour’s or your friend’s.” Factors that may help you make good investment decisions include being able to articulate the growth you hope to achieve, and the timeframe you are giving your portfolio to meet that objective.
OK, I think I’m ready for the next mania. Now what?
While no one can predict the next market mania, knowing how your brain reacts to the excitement of a rapidly rising stock means you may have an opportunity to use better reasoning ahead any investment decision.