By now, GameStop (GME +0.94%) fever has come and gone.
The remarkable story of a band of traders on Reddit pouring into the video game retailer's stock to execute an epic short squeeze that lifted the stock price more than 2,000% in just a few days is well known. The event captivated the country as search traffic for terms like GameStop and WallStreetBets skyrocketed, and even interest in Wall Street movies like The Big Short shot up more than 500%, according to streaming aggregator Reelgood.
New accounts surged on Robinhood and other trading platforms. In one day alone, the Robinhood app was downloaded more than 600,000 times, and trading demand was so high that orders for GameStop and other WallStreetBets-related stocks had to be suspended because trading platforms couldn't process the volume. Daily trading volume of GameStop exceeded the float by as much as four times.
Image source: Getty Images.
In the end, fortunes were won but also lost, and as many had predicted, GameStop stock ultimately cratered. The stock is now down about 90% from its peak share price of $483 on Jan. 28, and in the first week of February, it lost more than 80%.
Looking back, the most obvious reason why the rally was so hard to resist was the perception of easy money from the rally and getting rich quick. The stock was going through the roof, and it was too easy to assume, especially for newbie traders, that that pattern would continue. However, there are a number of other reasons that the stock became so appealing. In fact, many of them are cornerstone principles of marketing psychology.
Social proof gets put to the test
What's the simplest reason to want something? Because your friends have it.
Social proof is the concept that people will copy the actions of those around them. It's why brands use celebrities to pitch them, or why "millions served" is used as a classic tag line.
In the case of GameStop, many traders saw what was happening and told their friends to jump in, certain they'd come out with a profit. Everybody on social media, and elsewhere it seemed, was buying GameStop. In fact, GameStop may be the first case of a stock going viral as it took just a couple of days for the stock to go from basically forgotten to the talk of the nation.
It wasn't just ordinary millennials who were contributing to the viral effect, either. Several celebrity-entrepreneurs pumped up the stock and cheered the GameStop investors along their path. Among them were Tesla CEO Elon Musk, venture capitalist Chamath Palihapitiya, Barstool Sports Founder Dave Portnoy, and Shark Tank star Mark Cuban.
Gamestonk!! https://t.co/RZtkDzAewJ
— Elon Musk (@elonmusk) January 26, 2021
Lots of $GME talk soooooo....
— Chamath Palihapitiya (@chamath) January 26, 2021
We bought Feb $115 calls on $GME this morning.
Let's gooooooo!!!!!!!! https://t.co/XhOKL1fgKN pic.twitter.com/rbcB3Igl15
The encouragement from both celebrities and ordinary investors added to the frenzy around GameStop, pushing the stock higher, which only gave it further to fall.
"Everybody's doing it" may be a good justification for some things, but it doesn't usually work for buying stocks. With GameStop, the rush of buyers lifted the price of the stock well beyond fair value, and it's now falling back toward that level.
The scarcity creates an impact
Nothing motivates a sale like a limited time offer, or "while supplies last." Knowing an opportunity is fleeting forces potential buyers to commit, and it also makes the product in question seem more desirable as not everyone can have it. Another way to look at scarcity is "FOMO," or fear of missing out, a feeling that also helped drive much of the rally as traders didn't want to miss the opportunity to make a killing on GameStop stock.
While that strategy worked with GameStop early in the short squeeze, increasing demand drove the stock price higher and the opportunity ended within days, but not before thousands of traders would get stuck holding the bag on a stock about to fall through the floor.
Scarcity does play some role in the stock market. It's helpful to take advantage of opportunities such as high-quality stocks on sale, often called "buying the dip," but most investing isn't about scarcity. Long-term investors know that great stocks will keep compounding as they grow, and they will pay off even when you buy them at all-time highs.
The David vs. Goliath narrative caught hold
The most compelling part of the GameStop story was that a group of retail traders on Reddit had joined forces to outsmart the hedge fund managers who had shorted the retailer's stock. That forced both a short squeeze as the bears covered their bets and a gamma squeeze as market makers had to buy the stock to hedge their position as the value kept climbing.
That storyline attracted a lot of attention to GameStop and brought in new traders, thrilled at joining the crusade to take down the short-selling hedge funds, as many saw it at the time.
The reality was more complicated than that. Though it's true that hedge fund Melvin Capital took a $4.5 billion loss on its GameStop short bet, other hedge funds made money. Senvest Management, for example, made $700 million going long on GameStop, and plenty of individual investors lost money both shorting the stock or buying it before it fell back.
In investing, you never know who's on the other side of a trade, and it's foolish to look at a stock purchase as some kind of morality play that will inflict pain on the other side, even if it's emotionally satisfying to do so.
What it means for investors
There are plenty of takeaways from the GameStop rally, but one overarching lesson is that investors need to keep their emotions in check, especially at times when it's so easy to get emotionally involved. While investing is partially a numbers game of analyzing companies and assessing risks, it's also about psychology, a game you play against yourself. It behooves investors to understand how emotions can deceive you into making bad investment decisions. Some of the biggest mistakes investors make often stem from allowing emotions to control decision-making, rather than faulty analysis.
In the case of GameStop, many of the signs were clear. The stock was propelled by a viral storyline as much as anything else, and that surge led the price to become divorced from its fundamental value.
In investing, it's usually best to ignore the hype. GameStop is just the latest example of the kind of irrational exuberance that leads to bubbles bursting.
