This past week the news headlines were dominated (other than COVID – I’m so done with COVID, but unfortunately, it isn’t done with me) by the trading activity by large groups of retail investors in several small/mid-cap stocks. One familiar name for those with children or if you’re an adult gaming enthusiast is the bricks and mortar gaming retailer GameStop. These retail investors have been working in unison to aggressively buy call options (the right to buy the stock at a specified price and within a specified timeframe) on these names, not only driving prices higher but also expanding the leverage level attached to these names in the derivatives markets. Many of these traders are trading in very small amounts but are doing so through margin and option trading, which amplifies their influence.
GameStop, AMC, Blackberry and the other targets of these retail traders are now trading very far from fundamentals (Currently GameStop is as valuable as Tyson Foods or Iceland’s entire economy!). This activity reminds me of 1999 when at the height of the tech bubble, FOMO fever was at its peak. The key differences today are zero cost commissions, higher use of leverage, and App- based-trading platforms that have gamified investing. Combine these factors with the work-from-home environment, and you have a lot of bored individuals focusing on stocks. We all know how the tech bubble ended (not good for most investors), but I want to assure you that I don’t believe that the isolated actions in a few small-cap companies will lead to a widespread, sustained downturn in the markets. As I pointed out in my last commentary, we believe the path forward is an opportune one, but it won’t be a path of roses. It never is. Be prepared for a bumpy ride.
More importantly, though, I am reminded of how FOMO can affect our decisions. Last year I wrote about how 11-year-old boys and investors alike are afflicted by FOMO. The underlying message is that after a 13-year bull market, which included a global pandemic, investing can seem easy. However, risk assets and markets are driven by fear and greed and they vacillate between being valued and priced (if you don’t know the difference, read my earlier post on the subject). Successful investors understand what they are investing in, manage their risk religiously, and are fearful when others are greedy.
Reddit and the Greater Fool Game
These mob traders are playing the greater fool game. If acting in accordance with the greater fool theory/game, an investor will purchase questionably priced securities without any regard to their fundamentals under the hope that will still be able to quickly sell them off to another “greater fool,” who could also be hoping to flip them quickly. Unfortunately, speculative bubbles burst eventually, leading to a rapid depreciation in share prices. Compounded by leverage, this leads to significant and irreparable losses.
The meteoric rise and fall of this small group of stocks is nothing new. In the past, we’ve seen similar huge rallies and collapses in the prices of assets like crypto currencies, biotech, solar energy stocks, and entire equity markets. Investors get drawn into past returns, believing that recent returns confirm the story behind each of these assets. They jump on the investment, only to lose money when the bubble bursts.
Don’t get me wrong. I like financial bubbles.
That may sound strange, but financial bubbles have given us everything from railroads in the 1880’s to the internet in the 1990’s. Many of our most iconic companies and industries were either formed in those bubble environments or can trace their origins to their aftermaths. Notwithstanding the damage to individual companies and investors, bubbles leave behind a new commercial or consumer infrastructure. Bubbles also provide the opportunity for disciplined investors to add incremental returns, but to do so, investors need to keep their FOMO in check.
Sadly, most investors are not disciplined enough or have the breadth of experience to capitalize on bubbles. I would be lying if I said that investment professionals don’t suffer from FOMO or other cognitive biases as well. However, the acknowledgement that we all have biases is the first step in developing an investment framework that can help mitigate these cognitive barriers. Also important is the willingness and patience to diversify away into investments that are not in “bubble” territory. This can be hard to do since no one wants to be invested in something that just plods along for months or years before the tide turns. However, this is exactly what successful investors do. They put their emotions aside to analyze investment opportunities with data, not emotions or opinions. Those of you who know me personally know that I have little patience for opinions based upon anecdotal evidence or just plainly untrue assertations. As I like to say, everyone is entitled to their own opinion, just not their facts.
So, until next time, be sure to keep your FOMO in check.
Stay safe and be well.
Chief Investment Officer