The Gamestop Saga: What Economic Bubbles Teach Us about Behavioral Finance

“We are neurochemically confirmation bias addicts. We draw conclusions first, and only thereafter do we gather purported facts, only to see those facts in a way that confirms preexisting commitments. If they fit with our preferred narratives, so much the better.” 

• Bob Seawright, The Better Letter

98% of people are terrible at being investors. It has nothing to do with intelligence or education; it has everything to do with our caveman ancestors who, though they existed 10,000 years ago, are still driving our daily decisions. Cavemen had no opportunity to spend time thinking things through. If they took too long to make decisions, they got eaten by tigers and didn’t reproduce.

All these millennia later, we’re at the apex of human civilization. We think we’re rational, but the reality is, we take shortcuts all the time which can lead us astray. 

In a striking example of our caveman brains at work, we’re going to look at the recent Gamestop saga, and Bitcoin, which is back in the news. But before we discuss either of those, we’re going to talk about 17th century tulips. Everything old is new again.

Tulipomania

In the 1630s, Holland was an emerging world power. Based on textiles and shipping, they were rapidly industrializing, and new generation of Dutch people wanted to have luxury good. They began importing tulips from Turkey, and found them so novel and exotic that the phenomenon now known as “Tulipomania” set in. 

In those three years, the price of a single tulip bulb rose by a factor of 200. At its peak, a single tulip bulb cost 5,000 guilders — the equivalent of buying a mansion in Amsterdam. It’s among the earliest known examples of an economic bubble. That means that, just as quickly as it skyrocketed, the price of tulips crashed back to earth.

It’s easy to poke fun at the Tulipomaniacs because we think that now, several centuries later, we’re so much smarter. But as Gamestop, et al., have shown us is that we’re just not. These charts, which depict a stock or commodity spending years at a relatively stable price, then shooting up, then plummeting, happen all the time. 

Gamestop

Gamestop was a successful retailer throughout the 2000s, took a hit during the ’08 financial crisis, but then rallied again through about 2015. Every mall had a Gamestop. Kids would go in, play the games they had set up in the store, buy the new Call of Duty, and do it all again next year.

As Amazon, et al., started gobbling up market share. Gamestop went into a steady decline for the next five years. Gamestop paid dividends for quite some time, then stopped in April 2019, and were dealt a seeming deathblow by COVID-19. Brick-and-mortar retail was losing out to e-tail to begin with, and now, no one who still wanted to go to stores anyway. Bankruptcy seemed inevitable for Gamestop, and investors reacted accordingly. 

Hedge funds thought they could make money by shorting the stock at $5 a share. A short, in short, is when someone (the hedge funds, in this case) borrow the stock from someone who owns it, then sells it back at a later date. If the stock price goes to $0, which hedge funds figured Gamestop’s would, they make $5 per share. 

But on the other side are short squeezers. In Gamestop’s case, the squeezers were a hearty band of Redditors, a collective David, looking to take down the hedge fund Goliaths. Or, at least, that’s how the media portrayed them. It’s a great narrative, a moving one, and from an outsider’s perspective, it’s easy to root for David. Problem was, the narrative was almost completely false.

Maybe a year ago, some smart money began accumulating positions in Gamestop. Then, institutions investors got involved. For example, Black Rock is an asset manager with $10 trillion in assets. They have artificial intelligence software that sniffs through social media and finds out what the little people are buying up. Black Rock accumulated a position of about 13% of Gamestop by January 1. Then, the stock started to get some action, and the media jumped in. The media reported what they heard, which was that this was based on Reddit, David vs. Goliath — the story became popular, then everyone jumped in, precipitating the mania phase — the dramatic spike, which saw Reddit stock briefly cross above $400/share.

Here’s the problem: The smart money people have seen this chart before. They know this pattern, and they know to sell during the mania phase, when the price is unreasonably high. Then, there’s a big pullback as supply leads demand for the first time, and the stock falls sharply. Retail investors then think there’s a chance to get in, push it for a brief rally, and then it falls, because there’s simply a mismatch between the stock’s value and the stock’s price.

Anyone who got in early and sold during the mania phase made a big profit. On the other hand, many who bought during the mania phase and stuck it out until the plummet phase suffered losses of about 80% in just a couple days. It’s a ballistic rocket — it rises, rises, rises, then the fuel cuts off, and it falls, falls, falls.

As it falls, panic sets in.

Bitcoin

For a similar phenomenon (albeit different in a few key ways), let’s look to Bitcoin. 12 months ago, one Bitcoin cost $4,000. Now, one Bitcoin costs $57,000 — a multiple of nearly 15 in a year. This was fueled both by pandemic insecurity and the support of prominent investors; Elon Musk announced that Tesla had put $1.5 billion into Bitcoin and would begin accepting Bitcoin as payment for its automobiles.

Let’s go back in time a bit. For years after its inception, Bitcoin hovered between $250 and $1,000 per coin. Then, in Fall 2018, it ramped up to $20,000, small investors jumped in at high levels, and it fell 85% over the next year. The price went sideways for a while, until this most recent ramp.

Given this precipitous rise, one client called to ask me whether I’m any more interested in Bitcoin than I was when I turned it down in 2018. I told them that I’m as uninterested now as I was three years ago. Why? Because one of our rules is mapping price to value. Bitcoin’s current price is $57,000, but its value might be zero. 

Many people think Bitcoin will replace the dollar someday, but there’s a ton of infrastructure built up around the dollar and dismantling it won’t happen quickly or easily. More importantly, thousands of other cryptocurrencies sprouted up in the last few years, all of which are priced at or around zero. The probability of one product (Bitcoin) being markedly different than all the others is low, so there’s reason to think that Bitcoin’s actual value is zero. If the value should be zero, it stands to reason that the price will be zero eventually.

Psych 101

If this pattern has been playing and replaying itself out for centuries, why do we still fall for its promise? What’s the psychology that leads us to believe that this time will be different, that Gamestop and Bitcoin are savvy investments?

The answer lies with the cave people. 10,000 years ago, when we were looking for food, if we saw caribou tracks, it would be logical to follow them. Food almost certainly awaited where the tracks ended. The caribou tracks are like the upward spike in tulips, Gamestop, and Bitcoin; surely, our instincts tell us, profit awaits at the zenith.

It’s also Herd Instinct — if my neighbors are doing it, my friends are doing it, and lots and lots of Redditors are doing it, I need to do it, too. Herd instinct was useful back when banding together kept us safe from predators, but it’s hugely detrimental in economic bubbles. 

On the other side of the thrill of a spike is the panic of a plummet. Studies have found that losing a dollar feels twice as bad as gaining a dollar feels good — if x is pleasure and y is pain, x = 2y. This is because cave people had to be risk averse. They couldn’t afford to lose much, because losing could mean the difference between living and dying. 

Hunger; Herd Instinct; Fear of Loss. These are the primal instincts driving these bubbles. As investors, it’s our duty to recognize that primal instincts, though compelling, are often misguided. When used correctly, our well-developed, rational brains can show us better ways forward — ways that usually mean keeping our distance from bubbles.