Sam Sivarajan is a wealth management and fintech executive with a doctorate in behavioural finance. He is also the author of Money Talks: Lessons from Canada’s Wealthiest.
What do meme stocks such as GameStop and AMC have in common with the cryptocurrency craze? On the face of it, this sounds like a trick question, as they are very different types of investments. Behavioural science can, however, help explain how a few common themes underpin these seemingly different phenomena – and why they matter for investors.
First, it is important to note that these phenomena are reboots – and popular culture and history provide ample evidence. Consider meme stocks, which are shares of companies that, despite poor fundamentals, have gone viral because of social-media boosting. They are similar to a tech-fuelled version of the “pump and dump” tactics immortalized in movies such as Boiler Room or The Wolf of Wall Street, where aggressive brokers are peddling junk stocks to novice investors over the phone. We’ve also seen these tactics as far back as the Tulip-mania crisis in 17th-century Holland and the South Sea bubble in 18th-century England, which snared even the brilliant Sir Isaac Newton.
Cryptocurrency is, from one perspective, a tech-powered barter system marketed on the basis that it is free from control, manipulation, or scrutiny. It’s a modern form of “cash transactions” before money-laundering regulations came into force. But, as recent events have shown, there is now movement to regulate cryptocurrencies as well.
What forces drive the popularity of such investments? In behavioural science, availability bias is the tendency for people to overestimate support for a particular position based on a few sensationalized accounts. For example, a recent report titled The Hidden Tribes of America found that only about 33 per cent of Americans, at both extremes of the political spectrum, have strong and divided values and believe that this gap can never be bridged. These “wings” dominate the national conversation, yet the report says that 66 per cent of the population, the “exhausted majority,” have flexible and diverse views and believe they can find common ground.
Because the minority dominates the conversation online and in the media, their members become even more rigid and vocal, while the exhausted majority becomes even more disillusioned and apathetic. For meme stocks or cryptocurrencies, there is a small, vocal group of supporters compared to a large, silent group of the unconvinced.
Hence, availability bias means that we see these investments everywhere and become afraid we might be missing out.
Another factor is motivated reasoning, which is a form of confirmation bias. It’s a tendency to pay attention to and accept evidence that fits in with our pre-existing beliefs. This is illustrated by the classic study of a college football game between rivals Dartmouth and Princeton in the early 1950s. The researchers found the event and facts – a rough game with many penalties and injuries – were interpreted completely differently by the two sets of fans. Unsurprisingly, each thought that the other team was at fault for the rough game.
A more recent study had participants categorize ambiguous pictures as either faces or scenes. For each picture, some participants were financially motivated to see faces, others to see scenes; but in all cases, participants who guessed correctly would win the most money overall. The participants’ brains were scanned by MRI machines and the study found that, when motivated to see a face, the part of the brain processing facial features was more active – evidence that our subjective experience is impacted by our motivation. In other words, people saw what they wanted to see.
Thus, confirmation bias means that when we own a meme stock or cryptocurrency, we are even more convinced we are right and everyone else is wrong.
So, how do we address these behavioural biases and become better investors? Charlie Munger, Warren Buffett’s partner, takes what he calls an “invert always invert” approach. Rather than solve the problem in a forward manner, he suggests approaching it backward. He argues that this forces objectivity: Take your initial assumption and think about ways you can disprove it. In other words, ask yourself, “What would make me change my assumption? What am I missing?” This could mean asking what would happen to the share price of a meme stock if the social-media hype were to disappear, or asking how new regulations could affect the price of a cryptocurrency.
Mr. Munger’s approach is great advice for all of us, whether we are thinking about investing or joining an online political debate.
Your time is valuable. Have the Top Business Headlines newsletter conveniently delivered to your inbox in the morning or evening. Sign up today.