Intro
First a disclaimer: I hold no current positions in any of the securities discussed. This is not investment advice.
Another disclaimer: This article is as much for my own benefit as anyone else. This is my way of making sense of observations as the GME saga has unfolded.
As a student of Economics I have watched the GameStop mania unfold in recent weeks with great interest and I wanted to do an article around aspects of the bubble from a behavioural economics/finance point of view since I haven’t really seen much out there on this aspect.
First the story.
Most people will have heard of GameStop by now after garnering a vast quantity of media attention over the past few weeks. If you’re unclear on the details, read this section for a brief overview.
GameStop is a US game retailer with physical stores selling games and electronics. Given the shift to ecommerce, the COVID19 pandemic and the generally dismal long-term outlook for physical retailers, this might seem like an odd place for a speculative frenzy.
GameStop is a perennial loss maker with a market capitalization of less than $1bn before January. So why all this interest? The dark outlook for companies like GameStop hasn’t gone unnoticed by investors looking to short the stock in the hope of profiting from what seems like an inevitable demise. Several hedge funds took on significant short positions during the last couple of quarters of 2020. The most prominent of which is the $13bn hedge fund Melvin Capital, run by Gabe Plotkin.
Shorting simply means borrowing shares today and immediately selling them. Basically betting the share price will fall in the future. If the price falls the trader will be able to buy back the borrowed stock at a lower price, return them to the lender, and profit from the difference. It should be noted shorting can be very risky because the downside is potentially unlimited. A stock price can keep rising forever in theory. (Just ask the Tesla short sellers.)
All pretty boring so far. Enter Wall Street Bets.
Some users from the Reddit sub r/wallstreetbets took notice of the this high short interest and started buying GME call options and stock. In essence betting on an increase In the GameStop share price or rather to force an increase through concerted buying.
Reddit users over at WSB noticed that GME was the most shorted stock in the market with over 100% short interest. In theory this opened up the possibility of what is know as a short squeeze. The idea is the shorts have an expiration date, so when a stock unexpectedly rises in price it forces the shorts to cover. The way shorts cover is by buying the underlying (stock) to stop further losses as the share price rises. In other words, short sellers are being squeezed out of their positions by a higher stock price.
What WSB speculators saw is if they could collectively buy enough GME shares to drive up the price, they could initiate a short squeeze. Given the greater than 100% short interest and an decreasing number of available shares in the market, those investors with short positions would be forced to pay pretty much any price to acquire the shares to cover their short positions or suffer further spiralling losses. So the thesis goes. Since WSB users were the owners of large quantities of GME stock they stood to benefit greatly at the expense of the short sellers. Thus a bidding war erupted with WSB users furiously buying GME shares and call options. While short hedge funds postured and covered short positions.
This is indeed what likely occurred with GME at the end of January as the price of GME shares rose from $18 at the beginning of January to $350 on January 27th. Although nobody can be exactly sure to what extent a short squeeze took place. What is know is that by the end of January Melvin has lost 53% of its capital and required a cash infusion from Citadel and Point72 (two other hedge funds) to the tune of $2.75bn.
The story didn’t end there. Amidst frenzied speculation other stocks with high short interest such as BlackBerry, Nokia, and Cinema group AMC where caught up in the speculation amidst soring stock prices. Media attention caught on and this only further fuelled the frenzy of retail investors getting in on the action. The WSB forum grew from 2m users to over 8m in less than a week. Many of whom had never invested in the market directly before.
As the media become increasingly involved, an ‘us v them’ narrative emerged out of the chaos. Retail investors vs Wall Street. Man in the street vs the suits. This appeal to a social cause or populist dog whistle (take your pick) drove more retail investors to join the cause. Many pledging that it was no longer about making a quick buck, but giving Wall Street a black eye by weaponizing the options market. Indeed some hedge funds have lost billions on this bet, while others such as Senvest Management LLC who made $700 million from the GameStop saga have made significant profits.
Alas, what goes up must come down. As GME share price peaked retail speculators over at WSB continued to pile in and double down as the stock fell. Some under the persistent belief that the short squeeze had not yet ‘squoze’, while others wanted to be part of a perceived movement. Many are now sitting on eye watering losses after the stock lost 85% of its value during the first week of February. The frenzy of activity lead to stock exchange halts and retail trading apps to limit buying because they themselves were facing steep margin calls from clearing houses who settle transactions in the background. The Robinhood blog explains the mechanics in more detail.
Moving on from the controversy of story itself I’d like to delve into the behavioural aspects of this bubble. Not least because a large number of traders now sit on huge losses that may have been avoidable with some knowledge of the behavioural biases at play in these situations.
Speculative Mania
Speculative manias have occurred throughout history. The most famous early example is perhaps the Dutch Tulip mania of the 1600s. Speculative manias are characterised by a detachment from any fundamental basis or intrinsic value. The mania spreads as a social contagion by word of mouth. As more people hear about it, an ever growing number join in fear of missing out on some quick gains. This feedback loop expands the bubble rapidly, attracting new buyers, and inflating an assets price further above its intrinsic value. Inevitably a great bulk of people end up buying the ‘top’ as the mania reaches its peak and greatest extent. You can think of this like an inverted pyramid with a small number of early investors making fortunes and the vast bulk of late-comers holding the bag.
In the case of GME – an initial catalyst (short squeeze) started the trend. Then momentum took over. Once people started jumping on the hype train a bandwagon effect kicked in where adoption of the trend increases exponentially as a proportion of those who are already involved. Obviously this cannot go on forever, but for a while it can drive a mania beyond all rational limits. Each generation of new adopters rely more heavily on the second and third hand information from those already involved. Economists might refer to this as an information cascade.
MEME Stonks
The idea of ‘meme’ stocks encapsulates this idea of bandwagoning or social contagion carrying the salient ideas from mind to mind through hyperconnected networks like Reddit or Facebook. Under these conditions simplified narratives spread widely. The spread of false information and fake news spreads in much the same way. This meme-o-fication appears to have taken hold in some corners of the financial markets.
As the meme spreads herding behaviour occurs. This is common in financial markets – some people discover a market opportunity and exploit it, others see this and join in, eventually the opportunity is arbitraged out of existence. This is usually diffuse and invisible across countless market participants all over the world. The case of WSB is perhaps a concentrated form of herding, but still without a central coordinating mechanism or conspiracy. Herding arises spontaneously and isn’t pre-agreed.
This herd like behaviour became particularly apparent after GME shares ‘topped’ and started a precipitous decline. As the situation turned around and losses and anxiety mounted for WSB speculators, herding behaviour became tighter and stronger as each individual finds strength in closely sticking to the rest of the groups behaviour. This is natural in panic situations involving large groups of people. Especially when many of the late comers are reliant on the information provided by earlier adopters.
Crowds are driven by emotional impulses while individual identities and idiosyncratic differences are subsumed. People shift more toward relying on the group opinion for decision making rather than personal views or analysis. At WSB, any GME naysayers or alternative opinions were banned or downvoted into oblivion as the stock fell. Waves of optimism and pessimism spread moment to moment depending on the movement of GME price.
FOMO
Enter FOMO. Nobody wants to feel like they’re missing out on a opportunity. The feeling of missing out creates a sense of dissatisfaction even if you haven’t really missed anything. (we all miss almost every opportunity in the world at any given moment). As GME skyrocketed FOMO kicked in for both participants and those sitting on the side-lines.
For those already involved this will often take the form of doubling down. Wanting to maximize gains, traders will tend to become increasingly over-leveraged as the mania continuous. There are many stories on WSB of traders putting in their life savings or retirement funds into a single speculative stock, and many of those traders have suffered significant financial damage as a result. When FOMO kicks in the tendency will be to throw the usual rules out the window.
For those sitting on the side-lines FOMO usually takes the form of buying-in late in the game. These are likely more risk averse individuals, but the spectacle of momentum and terrific gains magnifies feelings of missing out and wears down resistance.
The WSB sub is pretty much built for FOMO because you have a community that prides itself on what it calls gains and loss porn. Others posting their gains and losses, and in some cases these can be life-changing amounts of money. People start imagining all the money they could make by getting in on the action. As a general rule maximum FOMO tends to peak around the peak of a bubble because the hourly/daily price movements become incredibly volatile at peaks. With GME daily swings of +-100% became common at the peak. How temping must it be to have the possibility of doubling or trebling any amount of money in 24 hours!
Loss Aversion
Loss aversion means people feel an equivalent loss more acutely than an equivalent gain. This loss aversion grows as the stakes increase. Many GME retail traders are more vulnerable to loss aversion because they take pride in YOLO-ing large sums, sometimes life savings into a single bet where the payoff is all or nothing.
FOMO creates a bias for buying high. Loss aversion creating a bias for selling low by hanging on too long to a losing bet. Hope also plays a role. The hope of a turnaround keeps the fear of future regret alive.
Buy high sell low is itself a meme on WSB for good reason.
During the GME mania WSB speculators often encourage each other to keep holding through peer pressure even as the price tanked. Everyone wants to exit without making a loss. Encouraging others to hold is one way to stop the bleeding. However, given the size of financial markets, it is unlikely to make any difference to a trend reversal.
Another tactic employed by WSB speculators is to simply not recognise unrealized losses as real. In a sense this is true, but in reality once a bubble has popped there is seldom much likelihood of recovering. Failing to recognise the loss as real early on just compounds the overall realized loss in the end.
Head In The Sand
As losses mount there is a tendency to ignore bad news or contradictory information. In behavioural finance this is know as the Ostrich Effect. Literally an analogy to burying ones head in the sand when things are going wrong.
The WSBs sub has become increasingly sceptical or outright hostile towards any negative news regarding GME as losses have grown. Who wants to hear bad news about something they’re heavily invested in right? Another way to look at it is the early stages of grief. (denial and anger)
Escalating Commitment
In addition, losses can trigger an escalation of commitment whereby faced with an increasingly negative outcome the individual persists in the behaviour. In essence ‘doubling down’ or throwing good money after bad because doing so validates previous decisions. On WSB there is an overwhelming trend of speculators continuing to invest even after they’ve already amassed significant losses. Even liquidating other safer assets to pour more money into GME.
One thing to point out is escalating commitment can work in both directions. When things are going well, doubling down can be the rational thing to do. More input means more output all things being equal. In an investment context it magnifies the potential gains. On the way down, as losses mount, the tendency is to plow in more resources to try and force the desirable outcome or at least limit loses by ‘averaging down’. This only increases total losses and is irrational.
We see this all over WSB where some participants who are already heavily invested kept plugging in more capital as the price fell, or ‘dollar average down’ as it is commonly referred. Otherwise known as catching a falling knife. DCA makes sense as a strategy when entering a position – it doesn’t make much sense as an exit strategy. If you find yourself in a hole, stop digging.
Escalating commitment also has the perverse effect of increasing the stakes which in turn may increase the effects of loss aversion, encouraging further commitment in order to avoid realizing the losses. This is how people come to ruin.
Endgame: The Prisoner’s Dilemma
The endgame of the GME saga for retail investors on WSB has a passing resemblance to the Prisoner’s Dilemma. A game theory inspired game.
Nobody wants to be left holding the bag, but demand for the stock is artificially inflated. Some will be left holding stock nobody wants – at least not at the elevated price for which most speculators brought it. How does this resolve?
We can simplify the analogy by adding just 2 players to a single move game.
Suppose that the two players are represented by red and blue, and that each player chooses to either “cooperate” (HOLD GME) or “defect” (SELL GME).
- If both players cooperate (CC) they can maintain or push up the price of GME which maximizes the rewards for all players in total.
- If one player cooperates by holding or buying more stock, but the other player defects (CD), then the price falls a little, but the defector is rewarded by being able to sell at a better price while the other player holds the bag.
- If both players defect (DD) by selling their stock the price plunges further and faster and they both loose out. The price has to fall further to find other willing buyers.
The incentive for each player will be to defect (sell the stock) and this is indeed the dominant strategy. While at the same time both will be compelled to convince the other players to hold. Indeed, retail investors were net sellers of GME as the price fell, but you wouldn’t get this sense from inside the WSB reddit sub where it would appear everyone is holding or buying.
Ignoring for a second all the complexity of the real world, and holding all other exogenous variables fixed – there was an all out effort by those still invested to convince the other players to hold the stock or so called “diamond hand” it. Meanwhile, the price plummets as insiders and outsider (funds) sell. Those who were suckered into “cooperate” are left to hold the bag.
In this framework even the narrative of ‘Main street vs Wall street’ plays an interesting role because it might get some of the players for whom this narrative resonates to hold the stock longer than they otherwise might. This benefits the defectors. Those who got in early, as well as outside funds who can benefit from this irrational behaviour.
Finishing Up…
Understanding the behaviour as well as the viewpoints of other market participants naturally lends some insight into the likely course of events. Behavioural finance has some general predictive power.
Advantage arises if you know what the other market participants know from their point of view, and you also know something they don’t know. Either through a better meta understanding of the behaviour of markets or some other information asymmetry.
Developing understanding of behaviour helps avoid falling into these common pitfalls and biases. This is particularly important in fast moving situations where emotions run high and momentum and hype cloud judgement. It is common for people who would otherwise never embark on dangerous speculations to be swept up by them. None of us are truly immune.
Keenly watching the GME sage unfold and making sense of it all has been fun. I hope you enjoyed this article. Let me know your thoughts in the comments.
Further Reading
If you find behavioural finance interesting I highly recommend a coupe of books:
Thinking Fast & Slow by psychologist and economist Daniel Kahneman
Manias, Panics, and Crashes by economic historian Charles P Kindleberger
