A behavioural perspective on…

RYAN   By Guest Blogger Ryan Lewenza

Getting tired of hearing about GameStop yet? No, ok, here’s some more red meat for you!

Today I’m going to review the GameStop madness but this time from a behavioural perspective, since what I’m seeing from these Reddit traders would make a behavioural finance professor roll over in their grave.

We all have behavioural biases that impact our emotions and in turn, our investment decisions. Behavioural finance is a growing field in the academic and investment world that studies these biases and how they impact our investment decision-making process. So today I’m going to review some of these biases that Reddit traders are exhibiting when investing in GameStop, so we can try to learn from these biases (and their mistakes) to be better investors ourselves.

The first obvious bias that jumps out is ‘overconfidence’. Overconfidence bias is the tendency of investors to overestimate their own skill, intellect or talent. This bias often manifests in excessive trading and risking taking, and ultimately, poor investment outcomes.

Are we seeing this from the Reddit traders? You bet!

Through the Reddit chatrooms they are pumping up GameStop, trying to induce more investors to pile in and drive the stock higher. There was no analysis of GameStop and how it was grossly undervalued. There was no consideration of the risk involved in buying a struggling company like GameStop. And there was surely little to no consideration of diversification or whether this stock made sense from a portfolio perspective. It was simply driven by more investors piling in, creating an unprecedented ‘short squeeze’, and on the hope that someone would pay a higher price in a few days (a greater fool).

To me this all screams overconfidence as these traders confuse their luck for skill (for the few winners that sold at the top), took incredible risks in buying this struggling company, all of which has led to a very poor investment outcome for most Reditt traders (GME is down 90% since its intraday peak of $483 on 1/28).

The second prominent bias is ‘pride and regret’. One of my behavioural finance books says it best, “People avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing that a previous decision turned out to be a bad one.

Pride is the emotional joy of realizing that a decision turned out well.” That is pretty insightful and accurately describes how many of us think about investing and realizing gains and losses.

I believe the GameStop traders are already feeling this regret as they begin to take realized losses and/or still mounting unrealized losses. I read one quote from a Reddit trader that said he didn’t care if he lost all his money, as he’s more interested in beating up the hedge fund guys. I think he’s saying this to make himself feel better about his big losses, likely having bought near the top, and now the reality that almost all of his investment is wiped out. He’s simply delaying recognizing his loss in order to avoid feeling regret over his poor investment decision.

So, ‘overconfidence’ helped to drive the stock from $20 to over $400 two weeks ago, but it is now ‘pride and regret’ that is prevalent as the stock craters 90% from its recent high.

Price Performance of GameStop

Source: Stockcharts.com, Turner Investments

The next bias that these Reddit traders are exhibiting is an extreme case of ‘herd mentality’, which is when investors blindly follow what other investors are doing. These investors fear missing out so they follow the ‘herd’ and all pile into the stock, in this case GameStop. The Reddit traders are not doing their own independent analysis, rather they are all just following the herd, hoping it will all work out and the stock will keep going up. This can work for a bit, but once the majority of investors who will be buy the stock are in, then there is no one left to buy and drive the stock further. Then, pop! The stock implodes, and we’re on to the next thing. Like a herd.

Lastly, I’m seeing a lot of ‘confirmation bias’ in the GameStop speculators, which is when we seek out information that confirms own pre-existing ideas and ignore contrary information. The Reddit traders are exhibiting this confirmation bias as they focus on the information/data that supports their thesis (the stock will go higher given the huge short position) while ignoring information that counters their pre-existing ideas (the bulk of shorts have covered the position and the stock is extremely overvalued). One important key to successful investing is to counter this bias by seeking out opinions and information that challenges our existing beliefs and be prepared to change our view if the information/outlook changes.

Emotions are a great thing, but when it comes to investing you really want to keep those in check. These behavioural biases that we all possess can stir emotions in us, and as I outlined today, can drive us to make poor investment decisions like selling after a big market drop, or buying GameStop in the $400s.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.