Until recently, the idea of getting your investment advice from social media, let alone from a forum like Reddit, probably seemed ridiculous. Trusting strangers to help you get “in” on the latest stock market fad is the antithesis of a sound investing strategy. But anyone watching the markets closely at the beginning of this year saw that certain stock prices soared overnight, and it wasn’t because these businesses had suddenly revamped their strategies and business models. All of a sudden “meme stocks” could be found across every news outlet.
What Are Meme Stocks?
A meme stock is a stock that has gone viral online and has attracted the attention of retail investors. These stocks are typically based more on hype than they are on the company’s actual valuation or performance. Instead, the value of these stocks increases because of forums on sites like Reddit.
You’ll likely remember some of the meme stocks that trended and increased in value this year. These included Blackberry, AMC Theatres and GameStop. Even Tesla has achieved meme stock status based on the attention it received in the Reddit retail investor message boards.1
Meme Stocks vs. Traditional Investing
The CFA Institute specifically defines a meme stock as a stock that has gained prominence on Reddit’s WallstreetBets discussion board.1 Once a stock crosses a certain threshold, the CFA Institute notes the date and begins to track information about the stock and how it performs on the market.1
What makes meme stocks a questionable investment is their volatility. The average volatility of these stocks before they became memes (“pre-meme”) was 83 percent.1 Depending on your risk tolerance and goals, these stocks may be too risky for the average investment portfolio. Once the stocks reached meme status (“post-meme”), their volatility jumped to an average of 106 percent.1
The Meme Stock Cycle
Unlike long-term investment strategies, meme stocks operate on a more volatile cycle. Meme stocks tend to follow a similar pattern:
- Early adopter
- Middle phase
- Late/FOMO phase
- Profit-taking phase
In this phase, a handful of investors have identified a stock that they believe is undervalued. These investors start buying this stock in large quantities. Early adopters tend to be the ones who benefit the most from investing in meme stocks.
As these investors begin buying stocks in large quantities, more individuals take notice and start to pay attention. Stock prices begin to increase.
The stock goes “viral” as word spreads across the Internet and social media. More retail investors join in the buying phase, driving the stock price up further. FOMO means “fear of missing out,” so many retail investors are jumping in when stock prices are already high.
Buying peaks after a few days, and the retail investors who were early adopters start selling their stock and cashing out. This starts a chain reaction, driving stock prices back down.
Key Takeaways of Meme Stocks
One of the positives of recent meme stock sensations is that it brought investing to the mainstream conversation. Now more than ever, people are talking about the stock market and educating themselves about investing.
If you’re considering jumping on the next trending stock, tread lightly and talk to your investment advisor first. While it may be exciting to think about, studies show that even the most experienced day traders lose money when they invest. Novice investors who bought stocks on margin may have found themselves losing money, or worse, owing money if they misjudged the right time to sell.
In most cases, it’s more beneficial to focus on your personal financial goals over the long run than getting caught up in short-lived investment trends. Instead of looking for the next hot stock tip, consider your risk tolerance, time horizon and goals. Work with your financial professional to determine if investing in a meme stock should be part of your portfolio, or if you’re better off sticking to a long-term investing strategy that will be able to weather normal market volatility.