GameStop stock surged by over 1,000% in 2 weeks: Understanding why can make you a better investor

"Recognize that you're wired to do everything wrong when it comes to money and investing."

People pass a GameStop store in lower Manhattan in New York City.
Spencer Platt | Getty Images

Forget Alphabet, Amazon, and Facebook. The stocks on nearly every investors' lips of late aren't the internet companies that are shaping the way people live. Instead, they're the companies currently benefiting from the way people on the internet are shaping the stock market.  

As of the end of trading on Wednesday, shares of brick-and-mortar gaming retailer GameStop had jumped another 135% on the day and were going for $347 per share — that's a 1,000% surge in just two weeks. The stock was the first of several, including movie theater chain AMC Entertainment and mobile phone firm BlackBerry, that have seen massive spikes in recent days, thanks to a buying frenzy among retail investors.

On social media, the stock surges have taken on the form of a battle between retail and institutional investors over control of financial markets.

Retail investors, many of them belonging to Reddit forum WallStreetBets, have bid up the prices of stocks that institutions, particularly hedge funds, have been betting against. That has triggered what's known as a "short squeeze" — a scenario in which short sellers (in this case, the hedge funds) are forced to start buying shares of an appreciated stock to mitigate their own losses.

With investors practically pushing each other over to invest in these stocks, several online brokerages, including Charles Schwab, E*Trade, Fidelity, and Robinhood experienced service disruptions on Wednesday, and TD Ameritrade restricted trades on GameStop and AMC, citing a need to mitigate risk for the brokerage and its clients.

But a chaotic few trading days doesn't mean that the American financial system is broken, says Douglas Boneparth, a certified financial planner and founder of Bone Fide Wealth in New York City. "Capitalism is working just fine — this is how free markets work," he says. "A lot of people are confused. Many people are making a lot of money. My guess is that there will be more people that lose money."

To avoid losing money on risky trades, it's worth understanding the financial psychology behind the stock market feeding frenzy, and crucially, how to overcome your biases to make sound financial decisions.

Understanding the investor psychology behind GameStop's rise

To understand market melt-ups, investors should know that investing is an act of collective optimism, says certified financial planner Brad Klontz, a financial psychology professor at Creighton University. "It's a collective delusion that we all believe, that we will take a dollar today and put it in something we think will be worth more tomorrow," he says.

Seasoned investors would argue that, under normal circumstances, stock prices are driven by the direction of a company's underlying fundamentals. Stock prices typically go up, for instance, when a firm's earnings are projected to rise.

Ultimately, though, collective behavior, not numbers, drives stock prices, says Klontz, citing the example of Tesla. As of January 27, the electric car company was trading at over 200 times its estimated 2021 earnings. "Is Tesla overvalued? Once the collective decides that it is, then it is," he says. "Fundamentals are relevant as long as we decide they're relevant."

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Many of the stocks receiving huge boosts from a collective of online investors look very poor fundamentally. It doesn't take a financial genius to know that a world in which video games are increasingly bought and streamed online rather than picked up at brick-and-mortar stores doesn't bode well for GameStop's future earning potential.

But once stocks start shooting up, a few instincts start to kick in among investors, Klontz says. A powerful one, he says, is the impulse to go where everyone else is going. "What you're experiencing there is really hard-wired in your animal brain," he says. "Think about how we survived as a species. When the herd is running in one direction, it's abnormal for you not to be really concerned that you're being left behind."

Is Tesla overvalued? Once the collective decides that it is, then it is.
Brad Klontz
financial psychology professor

This and other cognitive biases are amplified by social media, says Raife Giovinazzo, a partner and portfolio manager at Fuller & Thaler, an asset management firm that invests based on behavioral finance principles. "Once people started talking about these stocks online, there was a cascade of attention on them," he says.

As a result, some traders have acted against their better judgment, he says. "One cognitive bias we've seen among investors is recency bias — the idea that if something is working now, it will keep working," he says. "But fundamentally, there's nothing there. At the end of the day, we know GameStop isn't worth several hundred times what it was worth a couple of days ago."

Recognizing biases and cultivating good habits can help you invest wisely

None of that is to say that the people who have made a lot of money trading the likes of GameStop and AMC have done anything wrong. But traders who are late to the party could eventually get burned as enthusiasm for the stocks peters out and investors realize that the stocks may not be worth the price of admission.

"You need to recognize that you're wired to do everything wrong when it comes to money and investing," says Klontz. "If your fear of missing out leads you to day trading on speculative stocks," he says, "you're taking an approach that typically results in failure over the long term."

By recognizing that your emotions can lead to negative investment outcomes, you can establish habits that lead you to better decision-making, says Giovinazzo. "As an individual investor, I think the takeaway is, if everyone is looking over there, maybe I should look over here," he says. "With all the attention being paid to these crazy stocks, people aren't paying enough attention to solid-earning companies that have continued to deliver financially throughout the pandemic."

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If you're interested in trading speculative stocks, you needn't necessarily quit cold turkey, says Boneparth. Rather, you should create what he calls an "opportunity portfolio" — a small portion of your overall investment picture that won't derail your goals should the investments in it go south. Once you establish a core portfolio of diversified, low-cost investments, he says, "you can afford to be riskier in this small slice, whether you want to make momentum trades, invest in real estate, or buy digital assets."

"If you want to take 5% of your portfolio to explore investments and learn about the market, it's OK to get a little risky," he adds. "You just have to do these things in a disciplined and rational way. It's when you don't have these systems in place that you can run into trouble."

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