GameStop Mania from a Behavioral Finance Perspective
GameStop is a mall-based retailer specializing in video games and, like many other businesses, was strongly impacted by the pandemic. The company shut down a total of 462 stores in 2020. However, an unexpected turn of events caused the company’s stock to skyrocket by more than 1600% in January. GameStop, whose stock traded as low as $2.57 per share in April 2020, reached a peak of $483 in January 2021.
In reality, the retailer found itself in the middle of a price war between institutional investors on one hand and retail investors on the other. Considering the company’s poor performance, hedge funds seized the opportunity to short its stock, in hopes of realizing profits when share price drops as expected. On the other side, retail investors, who appear to be fueled by Reddit’s WallstreetBets community, had an opposite opinion. They subsequently proceeded to frenetically buy the stock in large volumes. The latter’s exuberance was so high that it ended up pumping GME’s price enough to trigger a short squeeze. GameStop turning into a “meme stock”, thanks to Reddit users, costed hedge funds billions of dollars in losses. Thus calling for regulatory scrutiny.
This article attempts to provide clarity around the GameStop mania using behavioral finance principles.
Just Another Bubble
GameStop’s wild ride has taken the world by surprise to say the least. It has been described as a once in a lifetime phenomenon. However, that is not entirely true. What happened with GameStop is not an unprecedented event as manias are not foreign to the market. GameStop’s frenzy resembles historical manias in a way. However, what’s particularly unique about GME’s bubble is the set of factors that contributed to its formation.
In his book “Manias, Panics and Crashes”, Charles Kindleberger describes a mania as a “loss of a connection with rationality”. This break from rationality is manifested by a price surge that cannot be explained by fundamentals, but rather is attributed to investor’s excessive enthusiasm that drives asset prices above their intrinsic value. Eventually, the bubble bursts leading to asset prices dropping sharply due to overall market panic. One of the most fascinating and earliest manias in history is Holland’s tulip mania in the 1630’s. Another great example is the Internet bubble during the late 1990’s and early 2000’s where investments in internet-based companies grew exponentially. Investors engaged in frenzy buying without particularly considering companies’ financial position. This caused stock prices to grow aggressively while investors carry the expectations that the companies in question will deliver future profits. When the companies failed to do so, stock prices decreased dramatically causing a market crash.
What happened with GameStop is similar to what is described above in the sense that the company’s stock price throughout the mania was not reflective of its fundamental value. With consistently declining revenue, it is undeniably a poor performing company who failed to adapt to changes in the video game industry. While the majority of consumers simply download video games online nowadays, GameStop still relies on physical stores. Now with the pandemic imposing restrictions and limiting access to malls, it is hard to imagine any prospects for the company.
Idealogical Investing or Irrational Investing ?
GameStop’s mania has received high media coverage over the past few weeks, ever since, people are still divided about retail investor’s real motives. In other words, while everyone is aware of the massive gap between the company’s fundamentals and the inflated stock price, nobody seems to fully grasp what triggered such a rally in the first place. What were Reddit users’ intentions when they engaged in frenzy buying of the stock?
The GameStop rally was portrayed by some as a populist trading movement. In fact, many seem to believe that this whole frenzy is nothing but revenge of the “small guys” against “evil Wall Street”. Trading restrictions later fueled this “us” versus “them” mentality. The narrative that is promoted depicts retail investors as ideological investors, who are not motivated by financial gains, far from it, do not mind losing all their savings to show support to the company and stand up against institutional investors. This idea is naturally against classical economics’ utility theory. Proponents of the ideological investing narrative back up their claims by several Reddit users posts. But should the GameStop saga be painted as a pure ideological movement or is there more to it?
Although the ideological narrative sounds sensational, it is not entirely true. At least, that is not how it all started. In fact, Keith Gill, who somehow became the face of the GameStop saga and later on testified in front of congress, claimed that he started investing in GME back in June 2019 because he believed the company was undervalued. Short-seller Michael burry and investor Ryan Cohen also invested in GME before it started to get attention. Influenced by the latter’s decision, a group of retail investors started to consider GME as an undervalued stock and see potential in it. Elon Musk later brought more attention to GameStop by tweeting about the company and sharing a link to the WallStreetBets Sub-Reddit. However, that was not enough to trigger a mania. What further fueled the situation was the short squeeze that forced short sellers to purchase GME stock and thus pushing the price further higher.
Entering the mania phase, and GameStop receiving more media coverage, intentions get a little blurry at this point. Millions of investors have joined the wave, further detaching from fundamentals and transitioning into irrational behavior. The herd mentality was fueled by Reddit, as users engaged in organized online buying of the stock. The platform’s posts suggest many reasons behind the frenzy ranging from wanting to make a profit, to nostalgia, to revenge on Wall Street or to mere entertainment. The truth is, the GameStop rally should not be tied to a singular motive. While evidence suggests several incentives it is difficult to settle on a single one. Every participant had their own motives to take part in the movement, but none of those motives was rooted in fundamentals. Depicting this mania as a purely populist movement would not entirely be true because it also attracted retail investors who saw an opportunity for profit. While portraying it as an solely profit-driven movement would not be a good representation either, since many Redditers shared their anger, frustration and desire to take “revenge” on short-sellers. Redditers sent many signals, but they all resulted in herd behavior. What started out as value investing, transitioned into a meme to then end in herd mentality with somehow blurred intentions. Consequently, it is safer to simply depict it as irrational investing, in other words, as a departure from fundamentals and from what classical finance stands for. Viewing this through a behavioral finance lens, allows for an open-minded picture and perhaps a more realistic one. The open-minded aspect of Behavioral Finance considers a reality where market agents are not always rational. In fact, the investor is subject to a number of cognitive and emotional biases that impair their capacity to take rational decisions. Here’s a number of biases that might have impaired investors’ decision making during the GameStop mania.
Regret aversion:
Regret aversion refers to how investors’ anticipation of a particular regret in the future impacts their decision making in the present. In fact, Psychology suggests that people’s decisions are highly influenced by regret or fear of regret. In the case of GameStop, investors who were reluctant at first, finally joined the movement, usually late, because they were afraid of missing out on potential gains as GME’s price surges. Regret aversion is also reflected in increasing initial investment and possibly using more leverage to do so. The bias is easily triggered in a community like Reddit where screenshots of generated profits were shared across the platform, showing users what they could be missing out on if they don’t follow the crowd.
Recency bias:
While it’s easier to understand institutional investors’ short position, retail investors’ position does not make a lot of sense. It is undeniable that GME’s stock price does not reflect any prospect for the company but rather just mere exuberance. Retail investors may think otherwise, but that’s because they were exhibiting recency bias, which means that they put too much emphasis on current stock price rally thinking it will extend into the future. In fact, too much focus was placed on current events in comparison to past ones, as stock valuation was overlooked.
Loss aversion:
Loss aversion simply means that the pain that is experienced from a loss is twice as intense than the pleasure from a gain. In fact, individuals are more open to taking risks when it involves avoiding a loss. In finance, loss aversion can be observed through the disposition effect, which is investors tendency to hold on to losing securities for too long and selling winning ones quicker. In GME’s case, investors may have held on their positions even when there was no prospect of a turnaround, hoping for a rebound especially that they were encouraged to keep their stocks because of posts on Reddit. Loss aversion bias is particularly prevalent during the panic phase of a bubble, when asset prices start to plunge.
Cognitive and emotional bises like the ones mentioned above lead investors into error and further away from rationality. Because of platforms like Reddit, investors’ errors become correlated. Investing becomes a social activity as users engage in debates and exchange success stories with each other. Consequently, individuals become exposed to the same behavioral biases and fallible judgment and thus their departures from rationality are more likely to be correlated.
What’s Special about the GameStop Mania ?
While manias are not new, GameStop mania is special because of the set of factors that contributed to its formation. First of all, the pandemic caused an enormous increase in stock trading. Research shows that retail investors are on a continuous rise due to boredom associated with lockdown. With extra money that people would spend otherwise on entertainment and travel, people allocate it to trading stocks. This brings us to the next factor, which is commission-free trading platforms like Robinhood that provide easy access to retail investors. Things that are provided for free, tend to be consumed in excess. That is exactly what happened with GME stock.
