What Are Meme Stocks and Why You Should Avoid Them

By Dr. James M. Dahle, WCI Founder

Over the last year, “meme stocks” have been featured repeatedly in the popular press and social media. This trend has been particularly dangerous for people who should be serious, long-term investors, but lack the financial literacy to properly build a diversified portfolio and follow a written investing plan.

 

What Is a Meme Stock?

A meme stock is simply a stock that is being talked about on the nightly news, around the water cooler at work, in Facebook groups and other social media platforms, and especially on forums or subreddits dedicated to stock trading and other short-term, high-risk investing techniques. If it is being discussed on r/wallstreetbets, it's probably a meme stock. Basically, like a good meme, a meme stock has “gone viral” on social and real-life media. It has likely just had a massive rise in value way out of proportion to its actual value as a business.

Examples of meme stocks from the last year include: Gamestop (Gamestonk?), AMC, Virgin Galactic, Plug Power, Palantir, Blackberry, and maybe even Tesla. There are even ETFs like BUZZ that simply invest in meme stocks.

 

 

What Is the Connection to Short Squeezes?

Many of the meme stocks have been tied to a short squeeze. Investors can short a stock by selling it before they actually buy it. In essence, these investors are betting that the price of the stock will fall. This is often done by sophisticated and wealthy investors via hedge funds. Other investors, for various financial and social reasons, decide to “short squeeze” the investors who sold the stock short. They do this by buying shares and bidding up the price of the heavily shorted stock. As the price rises, the short sellers are forced to cover their bet—in essence, buying high after selling low—which induces further price rises until the stock goes “to the moon” in a rocketship. Meme stock proponents often encourage each other to have “diamond hands” rather than weak hands that would sell too early.

 

Should You Buy Meme Stocks?

Short answer: No.

Long answer: Also no, at least not with any sort of serious money.

There are three reasons why you should not go out of your way to purchase meme stocks individually.

 

#1 You Already Own the Meme Stocks

Confession time: I own all of the meme stocks. If you think about it, you probably do too. They're all in the Total Stock Market Index Fund. Via that fund, over the last 17 years, I have bought Gamestop stock at prices ranging from $5-$50 a share. I benefitted from the price rise to almost $500 a share. It was a 10-bagger and even a 100-bagger for me. I was way better off than the people who didn't get in until $75 or $200 a share. Purchasing individual stocks instead of broadly diversified, low-cost, index mutual funds introduces uncompensated risk. Owning index funds always allows you to brag at cocktail parties, “Oh yeah, I bought that back when it cost less than $5 a share.”

 

#2 Speculation Is a Bad Habit to Get Into

Once a meme stock starts rising, its price has nothing to do with the underlying fundamentals of the company, which likely has at least some real assets and real earnings. Buyers are simply hoping they can find some sucker in the future to pay them more for their shares than they paid. In this respect, the investment has far more in common with speculative assets like gold, Bitcoin, empty land, or Beanie Babies than it does with the rest of the stocks in their portfolio. The key to long-term investing is to patiently purchase productive assets over the course of your lifetime. Stocks produce earnings, bonds produce interest, and real estate produces rents. A meme stock with a price-to-earnings ratio of 100 or even 1,000 or more produces nothing relative to the price paid. Yes, every stock has at least a bit of a speculative component, especially in the short term. But if a typical stock that's being held for the long-term has perhaps a 10% or 20% speculative component, a meme stock has a 99% speculative component.

 

#3 Meme Stocks Are a Short-Term Game

Finally, speculating in meme stocks is a short-term game. It is something you do over hours or perhaps days. It's more akin to gambling than investing. Investing is a long-term game, you against your long-term goals. Short-term investments don't really have a place there. Changing your focus from the long-term to the short-term can be particularly dangerous to a long-term investing plan. Behavioral finance issues aside, short-term investing carries significant transaction and tax costs. Like with cryptocurrencies, if you want to screw around with some tiny amount of your portfolio for fun, knock yourself out. But individual stocks, particularly meme stocks, are not a place for serious money.

Meme stocks—like NFTs, cryptocurrencies, and other exciting aspects of the markets—are great fun to watch, but your portfolio will likely thank you later for watching it from the sidelines. Or else your online account may look like this one:

 

 

Sure, this person only lost $13,000, but imagine if that had been $130,000 or $1.3 million or $13 million. There are gamblers in the markets doing that all the time. You should not be one of them.

What do you think? Do you “invest” in meme stocks? Why or why not? Comment below!