A chief risk officer offers the simplest way to fight back against stock-market memes

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OUTSIDE THE BOX

In a world where anything from a pixelated flying cat to a girl watching a fire can go viral and become a meme, can investors possibly assess what else might become a meme and impact their portfolios?

Video: How the meme stock craze is impacting small-cap investing (CNBC)

How the meme stock craze is impacting small-cap investing
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From my vantage point as a chief risk officer, “memification” will change the calculus for portfolio risk because meme risk cannot be modeled, much less measured. But it can be managed.

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The genesis of meme risk comes from trading for entertainment and for participating with the online community, the result of investment apps that allow fractional shares to be bought and sold with little or no cost. We have already seen glimmers of this in the explosive price action for GameStop and AMC crowd-sourced and untethered from any financial or economic reality.

These so-called “Reddit rallies” are just the beginning. Social network investment groups will literally turn the markets into a massively multiplayer online game. The thousands who worked together to vanquish short sellers from GameStop are not much different than the hundreds who banded together in the online game EverQuest to defeat the invincible dragon Kerafyrm.

The objectives of these groups need not have anything to do with an assessment of value, or anything else, for that matter. It might be as frivolous as entertainment, or perhaps as lofty as social statement. Meme investors might just as well band together to move the price of an oil stock over time to have the price chart trace out a smokestack. Or push up the price of food processor JBS Swift to commemorate Taylor Swift’s birthday.

What might be entertainment for some will be a profit opportunity for others. There is money to be made through misdirection and manipulation, further obscuring the footprint of risk.

So what can we do about a new type of risk that comes out of nowhere, arbitrary and unanticipated, unrelated to any financial or economic reality? The key is in the word “unrelated.” Like the aliens in War of the Worlds that are destroyed by pathogens, “the humblest things that God, in his wisdom, has put upon this earth”, the most elementary risk containment strategy of finance is the best weapon against this new and alien foe: diversification. 

As we know, if a risk is independent, it can be diversified away, literally brought down to be inconsequential if it constitutes a small enough portion of the overall portfolio.

When I have a sense of radical uncertainty, of a feeling that I can’t get a good handle on the sources of risk, my reflexive go-to is to increase the portfolio’s diversification. This means pulling back from positions that are overweighted and also reducing my reliance on correlations because there is no telling how those will shift.

This is, however, a strategy with a cost. Assuming all stocks are equally subject to meme risk, the ideal diversification strategy for that risk is to hold an equal weight across all holdings. Positions that are outsized will carry with them an added risk. The large exposure taken for return opportunities must be weighed against a higher risk.

In either case, a move toward an equally weighted portfolio is going to be attractive from a risk standpoint.

Rick Bookstaber is founder and chief risk officer at Fabric RQ. He previously held chief risk officer roles at Morgan Stanley, Salomon Brothers, Bridgewater Associates and the University of California Regents.

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