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How Meme Stocks Changed Investing

US News & World Report -  Money logo US News & World Report - Money 10/8/2021 Paulina Likos
Smiling woman drinking tea and using tablet in the caffe © (Getty Images) Smiling woman drinking tea and using tablet in the caffe

Meme stocks overtook the market in early 2021, with investors piling into companies gaining buzz on Reddit and other online forums in an effort to make money and outsmart hedge fund investors.

Outside of the internet buzz, these stocks were tempting to investors for several reasons. Their prices were low, market participants had extra capital to invest from stimulus checks, and investors recognized familiar names such as GameStop Corp. (ticker: GME) and AMC Entertainment Holdings Inc. (AMC).

Additionally, the internet and social media played an important role in driving attention to these speculative names and bringing the meme movement to the retail audience.

"Social media has made the accessibility and spread of (meme stocks) happen so much faster across geographic boundaries where people, who especially aren't in finance and investing, get pulled in because of the story itself," says Daniel Egan, director of behavioral finance at Betterment, an investing and saving app.

As a result, there are more novice investors participating in the markets to see if they can make a quick profit. And the emergence of those new investors can have far-reaching implications for investing as a whole.

So what is the lasting impact of meme stocks on the markets? Here's how meme stocks brought a new perspective on how market participants interact with their investments:

  • What is a meme stock?
  • The rules of trading are changing.
  • "Short interest percent float" is now a factor.
  • Early risk-taking can lead to better investing behavior.
  • A different investing approach.

What Is a Meme Stock?

A meme stock is a stock that captures online attention, usually from a younger generation of investors on online forums such as Reddit, and ends up going viral.

As a result, its market price is typically not in line with its fundamentals. In other words, the security's intrinsic value, which is derived from earnings growth and valuation metrics such as price-to-earnings ratios, earnings per share and dividend yield, may not be as stable as the stock price would suggest.

Meme stocks are volatile and often have massive price swings in a short time. And for some investors, not participating in the hype inspires FOMO, or the fear of missing out, on potential stock market gains.

Investor frenzy over meme stocks like GameStop and AMC has resulted in market participants making speculative trades on declining companies, causing an upsurge in their prices and major changes in their stocks' valuations.

The Rules of Trading Are Changing

Investing or trading meme stocks showed that the rules of trading are changing.

Traders usually stake out companies they recognize with an affordable market value and favorable technical setup, says Allison Ostrander, director of risk tolerance for educational stock market platform Simpler Trading.

With the meme stock craze, retail investors came piling into the market and quickly became a force to be reckoned with. Old-school investors didn't expect that retail traders were going to trade the stocks up, resulting in heavy losses for hedge funds that were shorting the stocks and had to close their short positions.

Meme stocks such as GameStop and AMC were not traded up based on their fundamentals. Instead, market participants were buying on momentum. This created a chain reaction, Ostrander says, where smarter traders were recognizing this as a brief wave to get in on and reap profits.

"(Retail traders) might not do the homework that hedge funds anticipate a trader to do – they're purely going in seeing this is a cheap buy," Ostrander says. New traders typically don't look at the company's background, she says. They're going to look at what's inexpensive and what companies they're familiar with.

'Short Interest Percent Float' Is Now a Factor

If a company's fundamentals are poor, it has not been uncommon for hedge funds to short, or bet against, a cheap stock.

Today, Ostrander says, hedge funds have to be mindful of "short interest percent float": shares held in short positions as a proportion of the stock's overall float, or tradable shares. This is a metric that retail investors are now paying attention to when choosing which stocks to pile into.

Short interest percent float is a measurement that gained popularity among traders during the meme rally. It's a way for market participants to find companies that hedge funds are gunning for and where there are not many shares left to short against, potentially forcing hedge funds to get squeezed out and causing volatile moves to the upside, Ostrander says.

Short interest percentage float for GameStop in January was around 100%, which means almost all the shares investors held were bet against the stock.

When short interest percent float is that high, a meme-stock trader may see an opportunity to profit on a company that hedge funds are piling into, so they can potentially force them out, or get them "squeezed out," of their positions.

Early Risk-Taking Can Lead to Better Investing Behavior

Meme stock traders may enter the market making speculative trades and taking outsize risks. But the good news is these new investors often learn quickly. Once they can assess the market and understand its dynamics, they tend to spread their investments toward other areas of the market. This enables them to learn and adjust their strategy as they grow their overall knowledge of investing.

"The idea of people taking their first steps of investing toward the speculative side of the market is not a new phenomenon," says Stephen Sikes, chief operating officer at Public, a social investing network. It's a common way for people to begin their investing journey, he says. They may start investing through stock picking but broaden their scope by diversifying.

According to a Public study on new retail investors, 81% of investors who purchased a meme stock said they went on to diversify their portfolios, with more than half of them in it for long-term investing.

"Putting that first dollar to work, even if its suboptimally allocated, is a net benefit to them in the long run because they get on this path that leads them into better corners of the market and ultimately a long-term investing strategy," Sikes says.

A Different Investing Approach

Today, Egan says, it's normal for investors to have more than one brokerage account. Long-term investors can open an account with Betterment, Wealthfront, Vanguard and other brokerages with a focus on creating an investment portfolio with retirement in mind. But the same investor may also have another brokerage account with a company like Robinhood where they can trade and invest in riskier or more speculative assets.

While investors have welcomed more risk with meme stock investing, experts say more traditional investors haven't necessarily shifted their approach from a long-term investing mindset to taking a more speculative short-term trading approach. Instead, it's somewhat of a combination of the two. The availability of different investment services has allowed investors to explore different ways to invest, Egan says.

"There's a diversity of ways people can interact with the markets, and they're probably doing more than one of them," Egan says.

The ability for investors today to engage with investments depends on their accessibility, or how convenient it is to invest in different ways. The easier companies make it to invest in certain securities, the more investors will jump into those products because there is guidance and comfort in the services provided.

"The more we build out services, the more we will see people using those services to invest in a variety of different ways, just so they have exposure to them," Egan says.

Copyright 2021 U.S. News & World Report


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