Let’s talk about biases: A behavioural look-back on the GameStop chronicles
By Madeline Quinlan, CFA 6 April 2021 7 min read
"What’s happening with Gamestop?"
"One day I’m going to need you to explain what a short-sale is."
"Can you call me?"
"What does this all mean?"
These were a handful of text messages I received as the narrative of GameStop unraveled early this year. The share price of the company rose by roughly 1,700% from the beginning of the year to its peak on January 27th, 2021. Three weeks later, the shares had lost over 70% of their value to the detriment of those investors that would have piled in late. Although the story is still playing out to a degree—with share prices recovering from the post-surge crash—January to the middle of February 2021 may go down in history as the GameStop chronicles.
As much of the initial attention fades from the story, we look to explain some of the key behavioural biases at work in a phenomenon that shares similarities to the Tulip Mania of the 1630s.
Tulip Mania is cited as the first financial bubble, a market phenomenon in 1636 following an outbreak of the bubonic plague in the Netherlands. A screeching halt to the majority of trading left limited commodities up for grabs by idle investors, and as a result, tulip bulbs became the subject of frenetic speculative purchasing, launching prices outrageously high, and subsequently seeing them come crashing down.
All financial bubbles, including Tulip Mania and the recent GameStop events, are characterized to some degree by human emotionality and faulty-decision making. To help us better understand how these phenomena arise, we can analyze and learn what behaviours and biases investors may have experienced along the way.
Understanding through the behavioural lens
Before discussing some key biases at play, let’s first start by reviewing traditional economic theory, which suggests that all investors are rational. This means that all of us should act in a perfectly sensible and predictable way after digesting all relevant information in order to maximize our utility (which just means to get the highest level of satisfaction). I’m sure we can all think of situations where we can admit to not displaying perfect rationality (you can just ask a loved one if you need an example).
It’s unsurprising, therefore, that models built on these assumptions do not reflect the behaviours that we see in the real world. Evidence of this is present in current financial markets, including market bubbles and subsequent crashes. There is also evidence of well over 100 (and seemingly ever-growing) documented biases—which are predictable, measurable patterns of error in decision-making—that can affect our financial well-being and the markets at large.
As a field, behavioural finance seeks to study, understand and mitigate these "irrational" biases—which are really just normal human decision-making behaviours that deviate from what economists would expect from “rational” investors. Within the series of events over the past several weeks around the GameStop saga, there are several examples that exemplify the shortfalls of decision-making due to such biases. Let’s take a closer look.
One of the most prevalent and impactful biases is confirmation bias, or the tendency to seek out and favour the information which supports our pre-existing beliefs.
Seen in many contexts outside financial markets as well, we often fail to integrate dissenting or opposing views, even when evidence would indicate its strength. Think of reading a favourable analyst report on a favourite high-profile tech stock, while ignoring the four additional contrary recommendations about the same investment, and continuing to hold the belief that you know you’ve got it made. Or, in the case of GameStop, continuing to read the confident predictions of “diamond hand” investors suggesting that returns will continue “to the moon” and treating such information as gospel.
Problematically, stronger confirmation bias bolsters a false sense of certainty and can be to the detriment of investing performance, as it ignores a wider lens for information gathering. As the media attention increased alongside the share price, so did the reach of Reddit investors’ unified message of increased gains. This further cemented the dedication of existing investors and convinced many others to jump-in which contributed to the explosion in stock price over such a short period.
Trend-chasing (ie. bandwagon or herding effects) may one of the strongest biases within investing and trading behaviour, particularly visible in “bubble”-like phenomena. Investors have a strong drive to follow the crowd and feel immense pressure to not miss out on what they imagine is a potentially huge opportunity for growth and investment returns.
This was extraordinarily clear in the case of GameStop. The herd was initially led by “notable/influential” investors, who had the support of the population mass of Reddit and the news media buzz around these particular investments. All of this helped lead investors to make an investment decision they might not have independently come to.
What started as a purposeful, intentional “herd” of Reddit investors, ended up catching on at a wider scale, gathering thousands of other investors in the market. As we saw with GameStop, if left unchecked and taken to an extreme, trend-chasing, bandwagoning or “herding” behaviour can result in overvaluation, eventual market bubbles and subsequent collapses, which was seen in the February free-fall of GameStop shares.
Overconfidence (often exacerbated by confirmation bias, above) is a bias exhibited by investors who hold the mistaken belief that they know more about an investment than they truly do. Experts and novices exhibiting this bias tend to overestimate their skills in their ability to make successful investment choices. This often leads to failures in judgement and decision-making which can ultimately result in excess risk-taking—although it may not feel like it at the time due to one’s sense of self-assurance.
The hedge funds, betting on prices falling, were certain they could outlast the retail investors which led them to hold onto losing short positions arguably longer than they should have. Conversely, the Reddit crowd and other retail investors were convinced they could hold on even longer, continuing to pump money into the already-inflated stock which would eventually have nowhere else to go but down.
Hindsight and attribution fallacy
There’s a reason for the adage “hindsight is 20/20”. Plenty of commentary from investors and experts alike, both in the case of GameStop as well as during other market fluctuations, reveal a sentiment of “I knew it all along” and “of course this was going to happen”. We are exceptional at “predicting the present” from a lens of our past selves or at least claiming to. Hindsight bias is a rewriting of our history, which protects our self-confidence and allows us to avoid regret when we look back at past decisions.
Associated with hindsight bias, is the attribution fallacy, or the association of successful outcomes to our own talents/picking and attribution of negative outcomes to circumstances beyond our control.
If you’ve ever taken an exam and done exceptionally, you probably said you studied and prepared. If you failed the exam, you might say the test was unfair, or that you were tired or the professor disliked you.
Unfortunately, while these biases are incredibly common and each certainly played a role in the GameStop chronicles, they are not completely avoidable. As the neuroscientist Antonio Damasio reminds us, “We are not necessarily thinking machines. We are feeling machines that think”. The reality of our imperfect rationality does not always bode well for our financial decision-making as investors, at least not when compared to traditional economics theory and its (unrealistic) assumption of perfect rationality.
As for where that leaves us as investors, fear not. Though predisposed, we are not necessarily doomed by our “irrationality” and propensity to exhibit such biases. The understanding and awareness of our own behaviour and potential pitfalls is the first step in improving our financial decision-making and staying on track to our financial goals.
Furthermore, establishing a financial plan that is aligned with our goals and risk tolerance will help guide our behavior and will leave us less prone to our own biases. Working with a dedicated advisor can be helpful in building a plan and can add another layer of protection from ourselves. By challenging us through collecting, analyzing and intentionally integrating information that may contradict our currently held beliefs and gut reactions, an advisor can help us avoid bias-driven decisions at inopportune times. This will help ensure that important decisions are made instead from the place of knowledge and sound judgement that built our financial plan.
By attempting to be as objective as possible through tracking our decision-making, measuring the outcomes of our choices and understanding that we are not immune from reacting to market fluctuations and events such as the GameStop saga, we can hold ourselves back from diving headfirst into what may end up being a regrettable decision.
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