Meme stocks: 2 of the hidden risks behind investing

Jonathan Smith explains how the high returns of meme stocks over the past half-year look attractive, but there are some risks to note here.

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Meme stocks are big news. They’re stocks that are associated with internet chat rooms and social media sites and can see major price surges based on groups of chat room users putting their money where their mouths are. If I go to Reddit or similar sites, memes are plentiful in making light humour about the share price moves of such stocks. But the term has only really become prominent since the start of the year, with GameStop being the first and largest meme stock. 

Meme stock FOMO

As an investor, my end goal is to generate the highest possible return on my investments with the lowest level of risk. So seeing the high returns from meme stocks in a short period of time is naturally appealing. But that’s only one side of the equation. Meme stocks carry with them several risks that aren’t immediately apparent.

The first risk is the fear of missing out (FOMO), an emotional bias we have as investors. This FOMO can make me act irrationally so I make choices that I normally wouldn’t. Meme stocks offer a high level of FOMO risk because retail investors that are leading the way here. It’s my hairdresser, my cousin and my tennis friends that have bought in. This contrasts to other stocks that are held more by pension funds or other institutional investors.

I have to be careful here because investing in meme stocks just because my friends have isn’t a very valid reason. I need to carry out my own research and be happy with buying based on my own convictions.

Issues with the long run

A second hidden risk with meme stocks is the investing time horizon. Usually, the longer my time horizon then the higher probability of the share price being higher than it was when I bought it. This is due to the historical long-term trend of stocks rising.

With meme stocks, this isn’t necessarily the case. The rush of buying offers high returns in a matter of days or weeks. But the consensus of many is that a share price has been pushed higher than the fundamental value of the business. Therefore, it’s unlikely to remain at such high levels in the long run when the retail investors have moved on to a new meme stock.

AMC is an example here. The US-based cinema operator has seen its share price move from $2 to $52 since the start of 2021. Yet 2020 results showed a whopping loss of $4.5bn due to the pandemic. I struggle to see the shares remaining so elevated for long.

High risk but high return

I don’t want it to come across that I’m completely anti-meme stocks. I’m well aware that some investors have generated large profits so far in 2021. I also acknowledge that if I’m aware of the risks of investing, then there isn’t anything wrong with me still deciding to invest.

After all, the high risk so far has been compensated by high returns. If this continues for the rest of the year, then some might decide that it’s worth it. However, from my point of view, the current levels of stocks like GameStop and AMC are dangerously high and so I can’t justify investing.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

jonathansmith1 has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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