What Are Meme Stocks?

The meme stock craze has ties to the COVID-19 pandemic, when lockdowns, economic stimulus efforts and soaring stocks attracted more investors to the stock market. Many stocks excelled from April 2020 to November 2021, as record-low interest rates and stimulus policies propelled the market to new highs.

While some corporations saw their stock prices rise because of strong financials and promising growth prospects, other stocks grew because retail investors poured their capital into them. Online forums and social media platforms such as Reddit Inc. (ticker: RDDT), YouTube and Twitter (now X) allowed more investors to interact with each other and push up the stock prices of smaller companies.

The meme-stock rally reached national attention amid run-up in GameStop Corp. (GME) stock in January 2021. GME shares soared by over 1,700% during that month as Redditors triggered a “short squeeze,” when big investors that had bet against GameStop were forced to exit their positions and buy back its rapidly rising stock to offset their massive losses.

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The balloon deflated, and shares eventually crashed. The stock has been volatile ever since, but GameStop’s meme nature reignited in May, as shares almost tripled from May 10 to 14. The catalyst was the reemergence of Keith Gill, better known as “Roaring Kitty,” who posted an image on X of a man sitting forward in his chair, a meme used by gamers when the action is getting intense. Back in 2021, Gill and others drove the frenzied buying of GME shares despite metrics that indicated the company could be headed for bankruptcy.

Here’s what you need to know about meme stocks and their pros and cons — but mostly their cons:

— Meme stock definition.

— The allure of meme stocks.

— Risks of investing in meme stocks.

— If you still want to buy meme stocks.

Meme Stock Definition

“Meme stocks are names that gain a cult-like following, typically due to trends in social media or popular investing forums,” says Bret Kenwell, eToro U.S. investment analyst. “These stocks can quickly gain traction, driving stock and options volume higher and creating elevated levels of volatility.”

The companies behind rising meme stocks have often taken advantage of their inflated share prices. For instance, amid the recent meme-stock frenzy, AMC Entertainment Holdings Inc. (AMC) disclosed plans to issue more than 23 million shares in a debt-for-equity exchange to pay off some of its obligations. The movie theater chain has regularly diluted investor shares during meme rallies. In another example, as retail investors pumped up its share price, Bed Bath & Beyond sold more than $400 million worth of stock before going bankrupt in April 2023.

The Allure of Meme Stocks

Many investors flock to meme stocks because they can realize substantial returns in a short period. They may chase high-risk opportunities in search of riches, such as when retail participation in options trading rose sharply during the pandemic.

Meme stocks resemble the tulip trading frenzy of the early 1600s, when speculators bought and sold tulips during Tulip Mania. Some traders made a lot of money trading tulips, but many ended up broke once the tulips lost their perceived value.

Julio Bedolla, wealth manager at LourdMurray, explains some of the psychology that drives people to trade meme stocks: “Investors are drawn to meme stocks for several reasons; the biggest, in my opinion, is FOMO (fear of missing out) on the next ‘get rich quick’ trend. Many times the psychology and emotion behind making a decision to invest in these meme stocks can be altered even more by the rush of risk-taking and the possibilities of what can come from making such a bet if it succeeds.”

Some people may view meme stocks as the only way to get ahead in a challenging economy. While the stock market marches to all-time highs, a survey of 38,605 people by PayrollOrg revealed that 78% of Americans are living paycheck to paycheck.

People are disgruntled about the rising cost of living, and that dissatisfaction is boiling over into several areas, including the stock market. Social networks bring these groups together. “People that actively participate in these social media discussions and platforms most likely get a sense of community and feel they are part of something bigger, which can be seen within the Reddit community,” says Bedolla. He adds that “going against ‘the Man’ by doing this can spark interest … and the idea of being part of a movement or fighting against institutional investors is appealing to many.”

Risks of Investing in Meme Stocks

Any stock carries a risk of losing your investment. Meme stocks come with more risk than the average stock due to their high volatility, however. Meme stocks also typically have poor financials and unappealing growth prospects, which suggest the rallies are temporary. Bed Bath & Beyond and Hertz were two meme stocks that ultimately filed for bankruptcy despite retail investors rallying around those companies.

“If these stocks do skyrocket higher, they inevitably come crashing back to earth. In that sense, investors who are too late to the party or who overstay their welcome can be burned, especially if they have a high cost basis. Increased volatility, both in the stocks and the options market, can exacerbate both the gains and losses, and therein lies the risk for investors,” Kenwell explains.

Meme stocks are speculative in nature and can tempt investors to make additional high-risk investments. Some investors may shift from trading meme stocks to trading options. While these decisions can result in substantial gains with good timing, most people end up losing their money from meme stocks and options.

Regularly investing in meme stocks can derail the development of good financial habits, such as investing in index funds and building an emergency fund. These stocks can also move you further away from your long-term financial goals. Combining meme stocks with margin investing can result in substantial debt that is difficult to repay.

If You Still Want to Buy Meme Stocks

Meme stocks can result in significant capital losses, but some people still want to make bets while the momentum is strong. Investors should go into any meme stock knowing that the music will eventually stop. It’s common for investors to sell out of their meme stock positions within a few days, weeks or months.

Keeping this in mind can make it easier to avoid getting caught up in the hype. Some investors hold on to meme stocks after logging 30% gains, only to see those gains evaporate within a few days. Double-digit-percentage swings are frequent with meme stocks, and locking in some gains may be better than getting greedy and going for the jackpot.

Benjamin Graham, the value investor who taught Warren Buffett, stated that the stock market functions like a voting machine in the short run, while it acts like a weighing machine in the long run. Today’s momentum can result in higher prices for meme stocks, but poor financials and a lack of growth opportunities will catch up with any corporation and its investors.

Investors can set stop-losses to lock in some of their gains or ensure they don’t suffer too much of a price drop. A stop-loss order results in an automatic stock sale if a share price falls below the level you designate.

Doing research on a meme stock before buying it can help you understand the risks. A further analysis may prompt you to back out of a meme stock instead of building a position. Investors should also only use money that they can afford to lose. Putting your life savings into a meme stock can result in significant losses and impede your path to long-term goals.

It’s better to invest in less-risky assets that have a dependable return or yield. Staying away from meme stocks can also allow investors to spend less time looking at their portfolios and embrace a passive investing approach.

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What Are Meme Stocks? originally appeared on usnews.com

Update 07/02/24: This story was previously published at an earlier date and has been updated with new information.

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