It is exciting to suddenly receive a financial windfall. That feeling is a natural part of how our brains work, irrespective of education or experience. Isaac Newton lost a fortune chasing the excitement of unexpected profits. As a scientist, he developed the theory of gravity. As a speculator, he lost sight of the fact that if prices of tulip bulbs can appreciate skyward, they can just as easily fall back to earth. Do you remember Pets.com from the year 2000? While there was significant demand for the stock when it went public, it filed for bankruptcy within a year. Will GameStop be remembered as 2021’s Pets.com? Likely.
If you have missed the evolving story of GameStop, here is a summary. It is a public company that sells computer games and consoles like Xbox and PlayStation mostly through small retail stores. There is nothing special about the company, and it competes with Amazon, Walmart, and BestBuy. Last year, it was worth around $200 million. Since then, without any material change to their product line, speculators bid up GameStop shares from a low of $2.57 to a recent high of $483 a share. On February 1, the share price was $225, a hundred times what it was worth last year and down 53% from its high. In subsequent days, it traded between $90 and $100. Tomorrow?
Speculation: paying too much in the hope that someone else will pay you even more.
Research has found that getting an unexpected reward generates a chemical release of dopamine in our brains. The “high” can be as addictive as any drug. We feel it when yesterday’s $100 purchase is unexpectedly worth $200 today. We will feel it again if the price goes up tomorrow and our brain generates another dopamine hit. Speculative winnings are seductive. Hungry for more, we hesitate to sell and lose out on additional profit. An insightful book on the topic is Jason Zweig’s “Your Money & Your Brain,” first published thirteen years ago.
Characteristics of the current environment may help explain the GameStop bubble. First and foremost, exceptionally low interest rates have pushed people into considering risky assets. Secondly, social media has enabled speculators to talk up specific stocks, commodities such as silver, and currencies such as Bitcoin. In addition, increased wealth inequality and the emergence of “free” stock trading apps such as Robinhood are pitting individuals against the Wall Street elite (of course, nothing is free – other firms pay Robinhood for information on the flow of trades). Each speculator may be motivated by one or more of these factors, but all feel the rush of sudden wealth created out of thin air.
Are there other bubbles to avoid?
A bubble is when the asset’s current price has no connection to its value. GameStop, a $200 million company, did nothing to become a $1.6 billion company in a couple of months. Same business, same competitors, same 70 million shares outstanding.
Other stocks may be trading above a reasonable valuation of their future earnings. Tesla, for one. At the current price, it is the world’s most valuable car company. While electric cars will clearly gain acceptance, it seems unlikely that most cars will be Teslas.
Bitcoin, an electronic currency, may be bubbly. It has no intrinsic value, but Bitcoin’s computer code does limit how many will exist. Scarcity can create value if there are sufficient demand and limited substitutes. While it may become a stable store of value, speculators have driven Bitcoin’s price to fluctuate between $4,100 to $41,000 over the past year. For a deeper explanation of why there is no underlying value, read our blog What Is A Bitcoin?
Silver’s sudden price jump may also be an indication of a bubble forming. Precious metals such as silver and gold have been well-accepted stores of value for thousands of years. Paper currencies, such as the U.S. Dollar and Pound Sterling, used to be based on specific quantities of these metals, and both gold and silver have value in electronic circuits and jewelry. Their price relative to each other has been stable until last week when speculators started to bid up silver, but not gold.
Bubbles always burst. It is merely a question of when and who gets hurt.
Time will tell the size and duration of a bubble. They usually continue for much longer than any rational person would anticipate. If Isaac Newton can lose money in tulips, intelligence is clearly not a factor. The brain releases dopamine irrespective of IQ. When the price of something is a multiple of its true value, the only way to be sure not to lose money is to sell before the bubble bursts, a hard decision since it eliminates the potential of another dopamine hit. Once speculators start to sell, prices drop fast, and there may be no buyers until it has fallen below its true value. Prices may fluctuate on the way down as some speculators buy in the hope of selling higher, but eventually, price reflects value.
How can I protect my life’s savings from speculators?
Reading about the irrationality of GameStop may create anxiety that the entire stock market is just a game. Some may fear that their investment portfolio is exposed to dopamine-driven speculators. Fear not; investing in the established capital markets is not a game.
There are two important distinctions between a stock and the stock market. The first is one of scale. Social media-driven demand can push up the price of a small company’s stock like GameStop. It is much harder to materially inflate the $50 trillion U.S. equity market above its fair value for long. The second is time frame. Money flows over time from overvalued assets to those that are undervalued. These flows cause the price of overvalued assets to drop and push up the price of undervalued assets. While daily stock market fluctuations may be greater than their actual change in value, markets find fair value over time.
Investors have a considerable advantage over speculators. The passage of time works against the speculator, who will only make money if they sell before the bubble bursts. Whereas an investor benefits from appreciating value of their investments which compounds with time.