Investors have discovered a new love for playing money games. Introducing ‘meme stocks,’ Wall Street’s latest craze. Born during the pandemic (when everyone, everywhere, was at home searching for something to do other than watch Netflix), the term ‘meme stock’ is used to describe a lagging stock that goes wild after going viral on social media. The trend was started by mostly young traders who, fueled by posts on websites like Reddit, Twitter, and TikTok, began investing in stocks with the goal of buying and holding to hurt short sellers and, ultimately, reaping their own riches.

For some, the approach worked, delivering massive returns thanks to the rapid rise of stocks like GameStop, Bitcoin, and AMC. It may have worked for them, but does that mean it’s right for you?

Learn before you leap

It can be hard to resist this potential road to riches, but before you leap into the frenzy, it’s important to understand exactly how and why meme stocks work.

What has generally separated meme stocks apart from highly traded stocks like Apple, Amazon, and Tesla is that an excessive number of short-sellers are holding positions in the stock. As their name implies, short-sellers borrow shares of an asset that they believe will drop in price in order to buy them after they fall. If they’re right, they return the shares and pocket the difference between the price when they initiated the ‘short’ and the actual sale price. If they’re wrong, they’re forced to buy at a higher price and pay the difference between the price they set and its sale price.[1]  If traders on social media target and buy such a stock, they can cause a sudden and massive increase in price with the goal of ‘squeezing’ short-sellers to sell their shares in order to cut their losses, enabling meme traders to cash in on the gains.

The catch

The catch, of course, is that meme stocks don’t always pay off. Achieving excessive gains on a meme stock requires getting in—and getting out—at precisely the right time. And like every get-rich scheme around, it’s much easier said than done.

To illustrate the point, the graph below shows the drawdown (the peak-to-trough decline) for Bitcoin, AMC, GameStop, and the S&P 500 in relation to how many trading days passed before that drawdown was achieved. In the upper left of the graph are assets that demonstrated short, shallow drawdowns, while the bottom includes assets with deeper, more extended drawdowns.

As an investor, the ideal is to see your investments clustered in the top left of the graph where the S&P 500 resides. In general, it’s best  to avoid positions in the bottom left quadrant—which is right where AMC and GameStop fall. While Bitcoin’s drawdown was also dramatic, losing over 80% in its largest drawdown since 2018, it appears in the lower right quarter of the graph because it took nearly a year to get there. GameStop lost that amount in just 6 days. 

The opportunity

If you love gambling in Vegas, meme stocks may seem like a great new game. Just be honest with yourself about the real ‘opportunity’: winning at this game requires faith in two things: 1) the Greater Fool Theory (which assumes that it will be possible to find a ‘greater fool’ who will gladly pay an even higher price than you did for an overvalued asset) and 2) a whole lot of old-fashioned luck. If you still want to take a seat at the table, here are three things to keep in mind:

• Make sure the core of your savings is balanced. 
  Before introducing risky meme stocks into your portfolio, be sure the core of your savings is balanced to protect against downside risk over the long term. A common benchmark for a balanced portfolio includes 60% growth/equity and 40% fixed-income/bonds. If you have those basics covered, you may have a little more freedom to gamble with some meme stocks. However, it would be smart to frame the size of your investment in the single-digits (or lower!) as a percentage of your portfolio. (Read more about how this mix works together to help protect your wealth in my article, How a Balanced Portfolio Protect from Downside Risk.)

• Split your high-risk capital among your favorite names.
  Warren Buffett has said, “Invest in what you know… nothing more.” If you’re in a place to invest in some high risk stocks, consider looking beyond meme stocks and buying some shares in a few of your favorite companies. If a meme stock or two makes the cut, so be it, but there’s no sense in loading up the truck with assets that are likely to rise and fall based on emotion, regulation, a Reddit post, or basic obsolescence.

• Remember the potential for losses.
  For every story about a 30-year-old trader earning millions overnight investing in a meme stock, there are thousands of stories of investors losing fortunes just as fast. If you choose to play the game, be sure you are prepared financially for the potential losses. If you can’t afford to gamble with your money—or you can’t stomach the idea of watching your investment disappear in the blink of an eye—leave the high-risk assets to high-risk investors.

Lastly, don’t let FOMO (the fear of missing out) drive you to invest where you shouldn’t. Although the stunning gains and losses of meme stocks make thrilling headlines, the most trusted way to accrue wealth is to adhere to a carefully constructed investment strategy designed to grow your wealth over time. Investing in meme stocks isn’t right for the majority of investors. If it’s not right for you, stick to the tried and true.

[1] Investopedia ,”short squeeze”

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