During Stock Market Manias, Ask These 3 Questions, Ep #130

Stock market manias have an uncanny way of capturing our attention.

Not only do they dominate weekly headlines, but create visions of what could be. The most recent example is the rapid rise of meme stocks, including Gamestop, AMC and Blackberry among others.

In this episode, we’ll explore what happened with this most recent mania, and describe the why behind how we can become enamored with this type of approach. We’ll then offer three questions to provide a framework for the next time you’re facing similar feelings.

How did the latest stock market mania play out?

This particular stock market hysteria surrounded GameStop. You may have seen a GameStop store at your local mall or shopping center. GameStop is a video game retailer whose future did not look promising. Many people compared it to Blockbuster Video.

This uncertain future attracted the interest of short-sellers and the retailer ended up becoming one of the most heavily shorted stocks. When an online Reddit group discovered what was happening to the stock, many people decided to jump in and squeeze the short. This sudden influx of investors drove the share price to unprecedented levels.

There’s a difference between gambling and investing

Manias are nothing new. We’ve seen them in many forms, including the Nifty Fifty in the 1950s, the tech bubble in the 1990s and BRIC Countries during the 2000s. The speed and size of these rallies often foster a fear of missing out motivation that is more analogous to gambling.

But there’s a fine line between gambling and investing. In stock market manias, it’s easy for people to throw risk considerations out the window because the possibility of life-changing gains takes over. Subsequently, this mentality too often leads to detrimental results when investors are using money they can’t afford to lose.

With Game Stop, investing quickly becomes interesting when the stock is increasing like a rocket ship within a week. For many, this strategy looks miles more exciting when compared to a disciplined long-term strategy. This is when the gambling temptation can circumvent the longer-term evidence based approach you may have used up to that point. Enter diversification.

That’s because diversification decreases your investment risk. When you diversify, you invest in many different types and sizes of companies which can be all over the world. The goal of diversification is to ensure the performance of one specific stock won’t kill your entire portfolio.

3 Questions to Ponder when Tempted

If you find yourself considering a specific stock purchase, there are a few questions that can help your decision.

What is this strategy claiming to provide that’s not already in your portfolio?
What will this investment reasonably add to your portfolio by including it?
- Could you increase your expected returns?
- Will it reduce volatility in your portfolio?
- Does this help you achieve a goal?
Are you going to be comfortable with the range of possibilities this purchase creates?

Your investment strategy will be most appropriate for you when it’s created in service to your financial plan. A plan that is specifically created for your goals and circumstances. Understanding the interaction between your income and future expenses for the next few years.

What will you need your savings rate to be?
How much longer will you plan to work?
Do you have other resources where this risk won’t derail your long-term financial picture?
Have you balanced your risk tolerance with the actual risk you are taking?

Carefully considering your investment decisions and ensuring that they align with a cohesive and diversified investment strategy will help you stay on target to reach your long-term goals.