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The soaring share prices of GameStop GME, -44.29% and AMC Entertainment Holdings AMC, -56.63% and others in day traders’ sights reflect two troubling stock-market behaviors currently on full display: the greater fool theory and the psychology of anticipated rewards. While these behaviors are shunned by quality shareholders, they reflect systemic woes that require scrutiny.
The greater fool theory is a trading gambit often used to exploit financial bubbles, when market price vastly exceeds business value. Traders know they are overpaying, but plan to sell to another buyer at an even higher price. It is not necessarily irrational, but it is high risk. During a bubble, as prices rise, the trader has a chance to make money, and some will succeed. But there is a vastly larger chance of losing money, and many will lose all their money.
There is only one ingredient needed to form a speculative bubble: a growing pool of buyers who, in turn, believe the pool will grow larger. Rising price alone draws new buyers and enthusiasm. Buyers feel validation, wealth and even power. As people share news of easy profits, the greater fool theory is self-sustaining. To quote Warren Buffett, “They create their own truth — for a while.”
The greater fool theory plays a role in every investing bubble, from the 17th century’s tulip mania to internet stocks in the late 1990s and real estate in the early 2000s. Reputable financial advisers will counsel against joining the crowds. After all, there is no way to assure the envisioned profitable sale goes through before the bubble bursts. It’s like musical chairs: you cannot know who will be left standing when the music stops.
But speculators ignore such advice due to the psychology of anticipated rewards. Neuroscience research shows that anticipation of gains, as from rising stock prices, produces dopamine surges akin to those of addictive drugs. Just like gamblers, greater fool traders take on excessive risk, favoring short-term gains despite long-term costs.
The psychology of anticipated rewards is likely to spread this current bubble far beyond the half-dozen stocks inflated so far. A growing mass of speculators are online at platforms like Reddit’s WallStreetBets, sharing market tips, while trading apps including Robinhood make playing the market cheap, fun and alluring to all. It’s a world of anti-Wall Street individualism, fixated on price not value, where a common mantra is “I feel a price rise.” An instant dopamine rush.
In recent days, the New York Stock Exchange halted trading in affected stocks and Robinhood ceased facilitating trades in them. Robinhood reversed course and now will allow limited buying in GameStop and other speculative stocks, but not before GameStop lost three-quarters of its market capitalization in 85 minutes after rising 700% this past week. Expect the Securities and Exchange Commission, which announced it is monitoring the markets, to ferret out unsavory ringleaders at these platforms and apps.
The SEC can pursue anyone behaving fraudulently — with the intent to deceive — or using manipulative or deceptive practices in juicing stock prices. While there is no visible evidence of such misconduct, flexing the SEC’s muscles may discourage using the greater fool theory and tame the psychology of anticipated rewards.
Meanwhile, the rest of us can update the famous quip from Joseph Kennedy, an original Commissioner of the SEC, who said when you start hearing stock tips from the shoeshine boy, you know there’s a market bubble. Today, the shoeshine boy is on Reddit.
Lawrence A. Cunningham is a professor and director of the Quality Shareholders Initiative at George Washington University. His books include “Quality Shareholders,” “Dear Shareholder” and “The Essays of Warren Buffett.” Cunningham owns stock in Berkshire Hathaway and is a shareholder, director and vice chairman of the board of Constellation Software.
More: GameStop and AMC show why you should practice trading before playing with real money
