In 1636, having a single tulip bulb in Holland was like having a million dollars in today’s money.
Why? Because of Tulip Mania. In 1636, the demand for tulips surged so much that the entire country was fixated on trading the delicate flower bulb—professional stock traders got in on the action, and people were buying more than they could afford on credit. But by early 1637, prices peaked and began to fall. Bulb holders were forced to sell and declare bankruptcy. By 1638, bulb prices returned to normal.Disclosure 1
Tulip Mania is often cited as an early example of a financial bubble: when the price of something drastically increases, not because of its actual value but because people who buy it expect to be able to sell it again at a profit.Disclosure 2
Now, the history books may have another example to cite from 2021 due to the phenomenon known as meme stocks.
Meme stocks made headlines in the first quarter of 2021 when everyday traders began pushing for short squeezes of hedge funds that bet on certain stocks failing—most notably, GameStop (GME) in January 2021. (AMC, Bed Bath & Beyond, and BlackBerry are a few others that became meme-stock favorites for the same reasons.)
But what exactly makes a stock a meme stock? Meme stocks can be difficult to define—and even harder to predict. Here’s what to know before you try to get in on the meme stock mania.
What is a meme stock?
Instead of positive company performance, meme stocks get their popularity from the hype created by amateur investors on social media and online forums like Reddit. The name is based on the internet sensation of memes—humorous ideas, behaviors, or styles that go viral. Just like their namesake, meme stocks are discussed at a rapid pace among traders, causing the stock to go “viral”—share values skyrocket well above their estimated value as people buy, buy, buy.
Brian Ford, head of financial wellness at Truist, says putting money in meme stocks shouldn’t even be considered real investing.
“The idea of investing is putting your money to work in something that will deliver value to other individuals, and therefore, grow in its fundamentals,” says Ford. “Meme stocks have nothing to do with that. In fact, it’s the opposite.”
How did meme stocks become a thing?
Meme stocks became a big deal last year among retail traders. Retail traders are essentially amateur traders—they’re nonprofessional investors who buy and sell stocks for their personal brokerage accounts, often from home and using online brokerage firms. Their portfolio size is dramatically smaller than institutional investors and hedge funds. Retail traders are a growing faction: In January 2020, 17% of all market trades were made by retail investors, but that number jumped to 25% by August 2020. And they’re young: The median age of traders on Robinhood, one of the most popular online brokerage apps, is 31 years old.Disclosure 3
In January 2021, retail traders began pushing for short squeezes of hedge funds that bet on certain stocks failing. The first meme stock that gained momentum was GameStop, which was valued at just $17.25 on January 4.Disclosure 4 By January 28, the struggling video game retailer had a stock value up about 2,700% to $483, fueled by retail traders who were trying to squeeze out hedge funds. One week later, the stock dropped 86%.Disclosure 5 A real roller coaster—that wasn’t fun for everyone who bought GME!
What is a short squeeze?
A short squeeze happens when investors bet a stock’s price will go down, but instead the price goes up. Here’s how that happens:
1. A stock is “shorted”: This happens when an institutional investor thinks a stock is overvalued and borrows shares to sell at the overvalued price. However, borrowed stocks need to be repaid at some point. The investor is betting on the stock declining in value so that they can pocket the difference between the price of the borrowed stock and the price at which they sold it. But in the event of a short squeeze, this could go in another, less desirable direction ...
2. The stock increases in value. If this happens, the investor must pay the difference. If they borrowed a lot of shares, this can add up fast.
3. Investors with shorts start to “panic buy” shares to try to mitigate their losses and pay back what they borrowed.
4. The sudden surge in demand increases the price even more, and there you have a short squeeze.
GameStop was just the first meme stock to go viral among retail traders and make mainstream news. Movie theater chain AMC, car rental company Avis, and home goods retailer Bed Bath & Beyond are just a few more public companies that became meme stocks in 2021. Their share prices soared as buzz began online, then they quickly fell. Now, many of these meme stocks are nowhere near their all-time highs, but they’re still considered to be dramatically overvalued in price.
Are meme stocks a good investment?
Meme stocks can be appealing to investors because they appear to promise a big return in a very short period. (Who doesn’t love easy money?) But they’re also super risky since their value isn’t based on the predictability of company performance, assets, and earnings—all things that typically make a stock hold value over time (and increase your earnings).
“I would classify investing in meme stocks as speculating,” says Ford. “Speculating is simply betting money on a highly unpredictable economic venture.”
Ford compares investing in meme stocks to gambling—but perhaps with less of an entertainment factor.
“It’s all just based on a trend,” he says. “We don’t really know where it’s going to go. We don’t know when it’s going to stop. There isn’t any actual fundamental value being delivered other than the fact that a bunch of people are buying it, and therefore, it’s artificially inflating the price.”
While a small percentage of people can make money on meme stocks, Ford says the majority lose because there’s no way of knowing when the stock will plummet.
Still want to dabble in meme stocks?
Although most financial advisors recommend against doing so, there is a more responsible way to approach investing in meme stocks if you’re intent on doing it. Ford says if you’re doing everything else right—you have an emergency fund, are growing your net worth, don’t have consumer debt, are maxing out retirement vehicles, have a diversified portfolio, etc.—then it may be OK to put a small percentage of money into meme stocks. “It would just be like play money, like going to Vegas and blowing $1,000,” he says. (It’s always wise to discuss your personal situation with a financial advisor before getting into risky investments, though.)
For most investors, time in the market is more important than timing the market. The way to gain wealth through the stock market is to play the long game, and meme stocks are just the opposite. Ford’s overall recommendation echoes that of other investment experts: “I think people should stay the course.”