#GameStonk - What Behavioral Finance Teaches Us About The Thrill and Agony Behind Stock Picking
Many of you are at least somewhat familiar with the viral investing trend sparked by the subreddit forum r/WallStreetBets. In short, a large group of retail investors assembled on Reddit, and through no-commission trading platforms like RobinHood decided to pile into heavily shorted companies to (a) make a quick profit, and (b) cripple large Wall Street firms that were behind the short positions. Arguing for or against the actions of this group is an enlightening, though borderline exacerbating, conversation that falls along the lines of Main Street vs. Wall Street.
We at SineCera Capital are not stock pickers. We believe that markets are usually efficient; trying to time or “beat” the market is incredibly difficult if not impossible. Capturing higher returns usually involves a combination of patience (i.e., long-term investment horizon) and illiquidity. Hat tip to Richard Bernstein (Founder of Richard Bernstein Advisors and the former Chief Investment Strategies at Merrill Lynch) who, on his recent investor call, reminded us of his most important adage regarding investment performance:
“Returns are greatest when capital is scarce.”
If you were lucky enough to purchase GameStop before January, congratulations. But, in 2021, I think you would be hard pressed to argue that there are too few investors looking to cash in on that stock (ditto, Bitcoin). A side-by-side comparison of GameStop’s meteoric crash-and-burn stock performance versus the surge in people searching the company on Google, highlights that many followed the herd; and unless they sold quickly, are probably down substantially.
GameStop Corp. stock growth (%)
GoogleTrends interest over time for gamestop
https://trends.google.com/trends/explore?date=2021-01-05%202021-02-05&geo=US&q=gamestop
It’s easy for professional investors to roll their eyes at the traders on r/WallStreetBets. Yet what has fueled this viral investing trend are the same behavioral biases that influence institutional investors, hedge funds, and other “Wall Street” investors.
Sunk Cost Fallacy
A sunk cost is a cost that has already been incurred and cannot be recovered. According to traditional economic theory, if an investor is rational, they would not make future investment decisions based on sunk costs. In the real world, when committing a substantial amount of time and/or money, it’s easy to be heavily influenced by those sunk costs and continue down a course of action, no matter how irrational. In other words, people are likely to fall into the trap of "throwing good money after bad.”
Loss Aversion
Sunk cost fallacy is innately tied to the cognitive bias loss aversion, which is our natural inclination to avoid losses rather than pursue a proportionate level of gains. In fact, a loss is twice as painful as the joy felt from an equal amount of gain. As a result, when an investment turns against us, rather than admitting defeat, selling, and realizing the loss, individuals tend to dig in. Oftentimes that involves taking even more risk in a Hail Mary attempt to recover the loss.
But why would someone decide to invest in GameStop to begin with if the potential for loss was so obviously high? By the end of January, when interest in the company peaked, GameStop was already up over 300% year to date. Believing one could generate a return far and above the potential loss (i.e., the entire cost of their initial investment) was more than enough to overcome any loss aversion. Unfortunately, as the tide has turned and GameStop is (as of this writing) down 85% from its peak, the sunk cost is now all too real.
These behaviors, and seemingly irrational actions, are no less prevalent in the upper echelons of the investment world. Just because they may have complex algorithms and detailed projections does not necessarily make institutional investment decisions more valid (Note: Garbage In, Garbage Out). GameStop was a heavily shorted position, and a short squeeze (now) seemed all but inevitable. Is it so wrong that information was capitalized upon by retail investors on a Reddit forum?
A Quick Story…
For those investors who got their first taste of the stock market by purchasing GameStop or another “viral” stock, this trial-by-fire experience will test your mettle. But you are not alone. My first experience with the stock market involved a small Ameritrade account and buying some of the hottest dot coms of the late 1990s (if only I had held onto Amazon!). Of course, what was at one point a near 4x return quickly disappeared in 2000. But it solidified a resolve to learn from those mistakes, become a smarter investor, and ultimately pursue a career as an investment fiduciary. Hopefully, this latest movement encourages rather than discourages others to pursue a similar path.
As always, if you have any questions, or would like to learn more about how SineCera Capital helps clients manage their wealth as a fiduciary, please do not hesitate to contact us.
Best Regards,
Adam J. Packer, CFA®, CAIA®
Chief Analyst | SineCera Capital
Disclaimer: The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of SineCera Capital. Neither SineCera Capital nor the author makes any warranty or representation as to the accuracy, completeness or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall SineCera Capital be liable to you or anyone else for damage stemming from the use or misuse of this information.