Meme stocks are the latest reminder of market psychology

The rally in so-called meme stocks, which captured the public’s attention earlier in the year, has returned for an encore performance. But this time around, the spotlight is shining on a new leading actor: AMC. Shares of the popular movie theatre chain jumped 250% over the past five trading days, as of June 1, seemingly on no news other than a group of retail traders taking an interest in the company. The sharp move higher pushed the stock’s year-to-date gain over 3000% and market cap just shy of $30 billion.

To put that into perspective, AMC is now worth more than half the companies in the S&P 500. But behind the jaw-dropping returns is a valuable lesson about market behavior and how advisors can help combat their client’s biases. 

The irrationality of meme stocks

One of the biggest challenges investors may face in their financial journey is themselves. Many don't intend for that to be the case, but in moments of euphoria, an investor's emotions sometimes cloud their better judgment. It can lead otherwise rational investors to sell during a downturn or chase a lottery stock to the moon.

The following innate qualities, which are the focus of behavioral economics, had a hand in creating nearly $30 billion in AMC market cap over the past few weeks. 

Overconfidence

Daniel Kahneman once called overconfidence "the most significant of the cognitive biases." Not because confidence breeds conviction but because it blinds us to failure. In investing, overconfidence is the illusion that success comes from intrinsic skill and awareness rather than external forces. It's why some investors believe they can successfully time the market.

Countless academic and industry studies have shown that this is easier said than done. An ill-timed decision to do either can result in below-average returns. In the case of the meme stocks, overconfidence may have led many investors to overestimate their ability to predict and explain the rapid price movements in stocks like AMC and GameStop. 

Herding behavior

The powerful network effects created on social media may have contributed to the recent FOMO or groupthink in the meme stocks. Members of communities—like WallStreetBets (Reddit) and FinTok (TikTok), to name a few—regularly witness this type of behavior. They encourage each other to pile into unprofitable stocks, and in this case, even banded together to intensify losses among professional short-sellers. For some investors, particularly in the AMC trade and the GameStop trade before it, the ability to be part of a bigger movement was a major selling point. After all, who doesn't want David to beat Goliath? But the truth is not everyone wins when the herd stampedes into fundamentally challenged companies. If anything, it often leads to irrational buying at the top, and worse, less selling as shares decline. 

Gambler's fallacy

There is a common belief among meme stock investors that once their stock of choice gets going, the good times will never end. Just look at the past week's Tweets of the phrase "to the moon." Many posters believe that the recent gains in the movie theater stock represent a broader trend, one in which shares will diverge further from its fundamentals. There is a willful ignorance to the fact that the stock can plummet. But no one is thinking about that now. This tendency to treat recent events as indicative of a bigger pattern is what psychologists call the gambler's fallacy or the representative heuristic.

The wild trading in meme stocks, which may be partly brought on by biased behavior, can distract investors from the big picture. Advisors can do a few things to help their clients from getting distracted in these moments. 

What advisors can do to limit biased behavior

A common phrase that often gets thrown around at times like this is "stay the course." Advisors repeat it to their clients to keep them from making rash decisions. The three words also serve as a reminder that a long-term investment strategy may not work if clients gamble a good chunk of their wealth on shares of GameStop, AMC, or the latest name trending on Reddit. So an advisor's job is done here. Well, not exactly.

Reminding clients about the benefits of long-term planning and investing is just one way to minimize cognitive biases. Another is to understand where the undesirable behavior stems from.

The biased behavior (some of which was listed above) that investors exhibit often starts in places where they get their information. In the past, investors may have leaned on their advisor for investment insights or general market commentary. That's not always the case anymore. Nowadays, investors, mainly those in younger generations, find information about the markets from advisors as well as in different corners of the internet like Reddit, Twitter, and even Tik-Tok.

Advisors should get comfortable with this new reality. No one says they have to drop everything, create a TikTok, and become the next FinTok influencer. But spending some time on platforms where the meme stocks were born and understanding the primary drivers of this phenomenon may help in countering a client's irrational behavior. 

Technology can also help in these situations. Modern investment platforms automate the most important parts of investment management, from creating a portfolio to rebalancing its holdings. Each step in the process is designed and optimized to meet the client's specific goals and needs. So even if a client wanted to bet the house on AMC, they'd know right away what effect that decision may have on their financial future.