Group Psychology of the r/WallStreetBets Short Squeeze.

A “short squeeze” is an adversarial trading technique where a firm buys a stock that another firm has shorted. When the stock price subsequently rises, the short seller must buy back the stocks it shorted at a higher price (further boosting the price). The results in a positive feedback loop, ultimately meaning huge losses for the short seller (and gains for the attacker) [1][2]

This is an advanced market manipulation technique used by large hedge funds to screw each other over, mostly because the aforementioned feedback loop requires a lot of capital to trigger. However, in January 2021, a small group of retail investors rocked the market by successfully short squeezing GameStop (GME), resulting in major losses for high profile hedge funds.[6]

This group of investors congregated on r/wallstreetbets, a brash Reddit forum dedicated to risky investments[11]. In early January, forum leaders noticed many hedge funds had huge short positions on GME. Realizing the possibility of a short squeeze, they convinced everyone on the forum to start buying GME through the commission-free investment app Robinhood[3][5]. The ensuing mass investment caused GME to soar 500% in just days (soon declining when Robinhood limited transactions, causing massive losses and accusations of anti-competitive malpractice).[7][17][18]

However, this behavior was not completely driven by financial expectation, as forum members regularly discussed how they are okay with losing money. In fact, there was an explicit anti-speculation moral argument made for participation[4][5], which drew support from anti-establishment investors and politicians including Elon Musk, Mark Cuban, Alexandria Ocasio-Cortez, and Donald Trump.[12][13][15][14]

Finally, r/wallstreetbets is not a serious investor forum. It traditionally features jokes and memes about high-risk investing, so it is surprising that such coordinated behavior could emerge from such a chaotic, anonymized forum.[11][20]

In short, this event was the result of complicated group psychology and deserves serious consideration, especially as the complexity of social systems increases daily. I will introduce 2 relevant psychological concepts, and use them to analyze the event.

The Bandwagon Effect

The bandwagon effect is when individuals make decisions based on what others are doing, not their own beliefs. En masse, this causes a surge of people to make similar decisions. In extreme situations, a significant social pressure to conform emerges. This is common in all domains of decision making, including sports, politics, and consumer behavior. [8]

Here are some principles that drive bandwagon phenomena:

• Humans find safety in numbers, which leaks into abstract decisions.

• The ‘fear of missing out’. The idea of friends doing things without you feels threatening, so people will go out of their way to be involved with trends. This is amplified by social media. [22]

• Decision making is cognitively expensive, so it is easier to ‘out-source’ decisions to others when available.

Bandwagoning is generally considered irrational behavior, especially when applied to mass cultural trends. However, the finance industry is interesting because ‘jumping on the bandwagon’ is a rational decision if timed correctly. Markets classically operate on ‘supply and demand’, so when lots of people start buying a stock the price naturally rises. Thus, joining the crowd quickly can make you a lot of money. 

Narrative-based decision making

This essay was inspired by Dr. Jacob Foster, a UCLA sociologist who studies collective intelligence. He is currently a visiting fellow at the Institute for Advanced Study at Princeton, where he gave a fascinating talk about his research on rigorous models of group decision making[9]. Foster argues that people fall back on stories to determine their actions in novel situations, especially in the absence of relevant episodic memories. The effect of narrative based decision making is amplified in a group context, because stories tend to be shared among others in the group. Highly coordinated action can emerge from a loosely related group working under a common narrative. 

Here are some reasons why stories are so convincing to a collective intelligence (synthesized from Let Stories Breathe by Arthur Frank[10]).

• Simple - Ideas conveyed by narrative are necessarily simple because they must be compressed into a sequential plot.

• Sticky - Good stories are engaging, striking a chord with the listener. This makes them memorable. 

• Viral - Stories are designed to be told. As we are acutely aware, exciting stories can spread through the internet almost instantaneously. 

• Actionable - Stories have characters, so you can easily slide into one and act it out, a process the cognoscenti call interpellation.

• Predictive - Stories have built-in consequences. This implicitly ties your actions to an outcome, which can be comforting in the face of extreme uncertainty, however irrational.

Tying It Together

Both Bandwagoning and Narrative-based Decision Making were large influences in the r/wallstreetbets short squeeze event. 

Bandwagoning is a more traditional group dynamic, and I think it played a large role in later stages of the movement. Once there was a critical mass of investment, the positive feedback loop that characterizes bandwagon effects amplified the movement onto the national stage. However, it does not account for the initial movement. 

I will stress the difference between the r/wallstreetbets situation and other instances of internet-based group behavior. Most other viral movements (for example, Kony2012) have a significantly lower cost of participation. For example, being involved could include tweeting about it or donating a few dollars.[19] The short squeeze, in contrast, required a very significant financial risk and a heavy trust of others in the movement (everybody needed to not sell, despite the 500%+ profit).

This difference suggests a richer instigating dynamic, and hence some new tools for analysis. Specifically, I propose Foster’s theory of Narrative Based Decision Making as the relevant lens. Remember, Foster hypothesizes that people make decisions based on narratives if they have no prior domain experience. The individual decisions involved in the short-squeeze fit this description well. This is because the investors were extremely inexperienced in stock trading, and there was a clear overarching moral narrative. [16][4]

The movement was largely driven by first-time, middle-class investors, many of which had just received a federal stimulus checks (regardless of employment status). This amounted to extra income, which could easily be invested in the down time of quarantine. [21]

However, note that picking stocks is an intimidating process, and it is not obvious what a new investor should do with whatever income they decide to risk.[16] This can be phrased as Foster’s ‘novel situation’ with ‘no relevant episodic memory’.

Forum members propagated a very simple story: if you buy GME, it will cause enormous losses to the rich people who “treat the US economy as a casino”[15][16]. Additionally, many participants were hurt considerably by previous speculation-driven financial crises, so it played into a deep seated need for revenge.[21]

The “stick it to the rich” narrative was critical because small, risk averse investors are unlikely to go for such a risky investment otherwise. The movement tapped into a deeper, highly-motivating resentment to get momentum.

In conclusion, this special mix of:

•  exploitable resentment towards large hedge funds

• a sudden boost of expendable income from federal stimulus

• extra free-time while social-distancing

•  enabling commission-free investment apps

•  the risk tolerant nature of the driving community

•  the objectively rational reason for the squeeze,

• and the fundamentally bandwagon-prone domain

created a tinder box for mass social mobilization. 

Thanks for reading.

References:

1. Definition of Short Selling https://www.investopedia.com/terms/s/shortselling.asp 

2. Definition of Short Squeeze https://www.investopedia.com/terms/s/shortsqueeze.asp

3. Timeline of Event https://abcnews.go.com/Business/gamestop-timeline-closer-saga-upended-wall-street/story?id=75617315 

4. Chohan, Usman W., Counter-Hegemonic Finance: The Gamestop Short Squeeze (January 28, 2021). https://ssrn.com/abstract=3775127 

5. Wall Street Journal -  The Real Force Driving the GameStop Revolution https://www.wsj.com/articles/the-real-force-driving-the-gamestop-amc-blackberry-revolution-11611965586 

6. Wall Street Journal - Wall Street Hedge Funds Stung by Market Turmoil https://archive.ph/E2vHu#selection-2679.214-2679.249

7. Abc news - Robinhood abruptly restricts transactions for GameStop stock https://abcnews.go.com/Business/robinhood-abruptly-restricts-transactions-gamestop-stock/story?id=75537922 

8. Definition of Bandwagon Effect - Investopedia https://www.investopedia.com/terms/b/bandwagon-effect.asp

9. Toward a Social Science of the Possible - Jacob Foster https://youtu.be/X28KwUzUCtk

10. Frank, A. W. (2012). Letting stories breathe: A socio-narratology. Chicago, Ill: University of Chicago Press

11. The r/wallstreetbets forum - https://www.reddit.com/r/wallstreetbets/ 

12.  Elon Musk support tweet - https://twitter.com/eloom/elonmusk/status/1354174279894642703

13. Mark Cuban Q&A - https://www.reddit.com/r/wallstreetbets/comments/lawubt/hey_everyone_its_mark_cuban_jumping_on_to_do_an/

14. Why AOC and Donald Trump Both Back the Reddit Investing Craze https://www.forbes.com/sites/jackbrewster/2021/01/28/why-aoc-and-donald-trump-jr-both-back-the-reddit-investing-craze/?sh=683f59c13e5e 

15. AOC support tweet - https://twitter.com/aoc/status/1354536220110577664 

16. Washington Post - As GameStop stock crumbles, newbie traders reckon with heavy losses https://www.washingtonpost.com/technology/2021/02/02/gamestop-stock-plunge-losers/ 

17. Robinhood Congression Hearing Transcipt https://www.rev.com/blog/transcripts/robinhood-ceo-testimony-transcript-gamestop-hearing-february-18 

18. Robinhood fined by SEC https://www.sec.gov/news/press-release/2020-321 

19. Jayson Harsin (2013) WTF was Kony 2012? Considerations for Communication and Critical/Cultural Studies (CCCS), Communication and Critical/Cultural Studies, 10:2-3, 265-272, DOI: 10.1080/14791420.2013.806149 

20. GameStop investors’ motives: Take a YOLO bet. ‘Ruin a billionaire’s life.’ https://www.latimes.com/business/story/2021-01-29/the-gamestop-brigade

21.  ‘Dumb Money’ Is on GameStop, and It’s Beating Wall Street at Its Own Game https://www.nytimes.com/2021/01/27/business/gamestop-wall-street-bets.html 

22. Fear of Missing Out https://web.archive.org/web/20150626125816/http://www.jwtintelligence.com/wp-content/uploads/2012/03/F_JWT_FOMO-update_3.21.12.pdf