Spring 2021
Recently, investors have banded together on unconventional platforms to drive up the prices of a handful of “meme stocks,” seemingly without traditional evaluation of investing risks and rewards. They made headlines with their “short squeeze” of GameStop (GME), and their tactics continue.
The efficient market hypothesis (EMH) says that prices reflect all available information. This leaves a lot of room for interpretation. Should asset prices be set by rational investors whose only concerns are systematic risk1 and expected returns? It seems implausible to link recent meme-stock price movements to economic risks. Rather, they seem fueled by investor demand to be part of a social movement, hopes to strike it rich with a lucky stock pick, or plain-old schadenfreude.
The vast ecosystem of investors ranges from individuals investing in their own accounts, to governments and corporations who invest on behalf of thousands. This complex system generates the demand for stocks. Another complex system fuels the supply of stocks. Supply and demand meet at the market price. While the stock market is not always efficient, or rational, it is always in equilibrium. Every trade has two sides, with a seller for every buyer and a profit for every loss.
A huge increase in demand for stocks often creates a run-up in the stock price. Some of this price increase can be temporary and reversed once the tremendous liquidity demands are met; this happens when an index such as the S&P 500 is reconstituted.2 It is well documented that liquidity demands can produce temporary price movements.3 Investors may wonder if temporary price dislocations motivated by users of r/WallStreetBets differ from those caused by changes to an index. When lots of buying puts temporary upward pressure on prices, they later fall back to fundamental value. Markets are complex systems, well adapted to facilitate the supply and demand of millions of market participants.
We believe investing as if markets are efficient is a good philosophy for building long-term wealth. Investors can be best served by using historical market performance, rather than chatrooms, for guidance on prudent investments best able to meet goals. Trying to outwit markets might be a quick way to destroy wealth.
Footnotes
- Systematic risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved.
- Reconstitution involves the re-evaluation of a market index. The process involves sorting, adding, and removing stocks to ensure that the index reflects up-to-date market capitalization and style.
- For example, see “Tesla’s Charge Reveals Weak Points of Indexing” (Dimensional, 2021).
