Are you considering investing in meme stocks? Here’s the Smart MNE guide on the do’s and don’ts and what it might "meme" for your wallet.
I’d like to thank the debut of zero-commission brokerages like Robinhood for enabling the average Zoomer to blow their trust funds on investing and sharing it all over social media for the rest of us to laugh at. The bull market of 2019 to 2021 certainly helped too. Money printer go brrrrt.
Unfortunately, recent rising interest rates have made YOLO’ing large sums of money into terrible options plays and walking away with a Lamborghini slightly more difficult. However, that hasn’t deterred new investors from trying to beat the market. I went over a few “proper” ways to do so here and here.
For most Gen Z investors, the concept of buying and holding a simple index fund, making consistent contributions, and staying the course is alien. For many, going all-in on a volatile stock with poor fundamentals but an ardent online following just makes sense. Hence, the birth of meme stock investing.
What are meme stocks?
Meme stocks were not really a thing prior to 2020. Sure, there were online communities dedicated to promoting and discussing particular stocks. These were nothing compared to the magnitude or absurdity of the contemporary meme stock craze.
A brief history of meme stocks
Meme stocks exploded onto the scene in January 2020 thanks to r/WallStreetBets, a redditor named Keith Gill (AKA “DeepFuckingValue,” or DFV) and GME stock. The tl;dr is that DFV did his CFA-level fundamental analysis on GME and noted it was potentially undervalued.
Reddit apes latched onto his thesis while simultaneously discovering that the stock was excessively shorted. A movement began to pump the stock in order to induce a “short squeeze,” which succeeded and caused hedge fund Melvin Capital to implode.
Since then, GME has pumped and dumped numerous times. Other meme stocks also came and went. During the January 2020 squeeze, it was AMC, BlackBerry (BB), and Nokia (NOK). Later in August 2022 came Bed, Bath & Beyond (BBBY).
Characteristics of meme stocks
We can differentiate a meme stock by its, well, meme-ness. These stocks are associated with a subculture that may display many of the following characteristics:
- Reverence for a central public figure (such as GameStop chairman Ryan Cohen and AMC Entertainment CEO Adam Aron).
- The use of subculture-specific language, like referring to each other as “Apes” or “Smooth Brains” (referring to a lack of wrinkles in their brains, thereby implying they’re stupid), and talking about “diamond hands” (an utter unwillingness to sell no matter what).
- The practice of an esoteric subculture-specific ritual (the direct registration, or DRS, of their stocks, which apes believe will prevent naked short selling by hedge funds).
- Demonization of an “enemy,” often SEC chairman Gary Gensler, Citadel CEO Ken Griffin, “Hedgies” (hedge funds), or “MSM” (mainstream media).
- Decrying any contradictory evidence to their thesis as “FUD” (fear, uncertainty, and doubt) and labeling any nay-sayers as “shills.”
- Belief in a day of reckoning or rapture, in this case the “MOASS” (mother of all short squeezes), where the price of their chosen meme stock will soar to “phone digit prices.”
- Numerous schisms within the community due to differing beliefs/figureheads, leading to splintering factions (like how GME now has multiple different subreddits).
Should you invest in meme stocks?
In the book, “Security Analysis” (1934) Benjamin Graham (Warren Buffett’s mentor) noted that “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
If you agree with his definition, then meme stocks clearly don’t have a place in an investment portfolio. However, they can be decent speculative plays. Let’s look at the optimal ways to get involved with meme stocks.
Short-term options trade
Meme stocks are prime stomping grounds for options traders thanks to their high volatility and strong volume. Some successful basic strategies I’ve seen include:
- Delta-neutral strategies like a straddle to hedge against any violent up or down movements while still profiting from changes in implied volatility.
- Holding 100 shares of the underlying meme stock and selling covered calls to receive a juicy premium thanks to the high implied volatility.
- Holding enough cash to purchase 100 shares of the underlying meme stock and selling cash-secured puts to receive a juicy premium thanks to the high implied volatility.
Long-term buy and hold
Meme stocks generally make terrible long-term buy and holds for your retirement portfolio due to several reasons:
- Poor fundamentals: Many meme stocks have negative earnings per share, slowing (or outright declining) revenue growth, no profitability, negative cash flow, etc. Think of your average dying brick-and-mortar retail business selling niche products.
- High volatility: The standard deviation of a meme stock is many magnitudes greater than an average index fund. A meme stock investor may have to tolerate swings of up to 10% or more intra-day. Volatility is an enemy to long-term returns due to how the geometric mean works. Behaviorally it can cause capitulation and panic selling.
- High kurtosis and negative skewness: This refers to how the distribution of returns from meme stocks has “fatter tails” than an index, and how the probability of losses is higher. Essentially, your chances of suffering a negative event are disproportionately large.
A speculative YOLO
If somehow you can’t cough up the money for a weekend in Vegas, betting a small amount on a meme stock could satisfy that gambling urge. Putting a small percentage of your capital down as a moonshot bet isn’t the end of the world if you practice good risk management. This means having rules in place for when you cut losses or take profits. A good rule of thumb is: If it’s good enough to screenshot and brag about, it’s good enough to sell.
The future of meme stocks
Meme stocks won’t be going anywhere. The explosion of new investors on social media sites like TikTok and Reddit will only lead to more downtrodden small- to mid-cap stocks gaining meme status and going on roller-coaster rides. I always advocate for rational investing behaviors, so I cannot in good faith recommend investing in meme stocks.
For cold-blooded traders, meme stocks could be a great opportunity to profit off market inefficiencies and investor mania. For long-term investors, meme stocks are best avoided. In this case, creating a diversified investment portfolio of low-cost index funds is probably the best way to go. If you really need to scratch that gambling itch, buy a lottery ticket.
I’ll end with a quote I’ve heard somewhere before: “The price of a meme stock can stay irrational longer than you can stay solvent.”