Mapping the origins of novel market phenomena: From meme stocks to climate risks
Sprott Assistant Professor of Finance Shi Li is deeply interested in the incentives that drive new phenomena in the financial market. His diverse program of research is held together by his quest to understand how investors respond to new events in the world around them.
In one research project, for example, he seeks to generate knowledge about the factors that contributed to the recent “meme stock” frenzy. Meme stocks are a special category of lottery-like stocks. Most of the time, these stocks lose money, but just like a conventional lottery, which sees participants pay a fee for the chance to win a jackpot-size profit, lottery-like stocks tempt investors with the potential for a large payout. Where meme stocks differ from traditional lottery-like stocks is in their connection to social media: their value skyrockets because they go viral on forums such as WallStreetBets.
In addition to contributing to the literature on social finance, a fairly new area of academic study, Shi’s work on the meme stock phenomenon has implications for retail investors (regular individuals who buy and sell securities and funds) and policymakers alike.
“Since retail investors have a relatively low level of financial literacy, they can be easily lured by social media influencers. They get excited by the juicy return posted by these people and mimic their investment decisions, believing that they’ll also get rich quickly. They hold extremely risky investments with their so-called “diamond hands” long after more savvy investors have cashed out.” The results can be devastating: “one retail investor risked his father’s entire pension and then committed suicide when he realized that he had lost it all.”
Low levels of financial literacy among retail investors also make such meme stock holders susceptible to losses brought about by fluctuations elsewhere in the stock market. Preliminary outcomes reported by Shi in “Spillovers between Bitcoin and Meme Stocks” point to a unidirectional wealth transfer phenomenon from meme stocks to bitcoin. In other words, when bitcoin performs well, money flows from meme stocks to bitcoin; however, when bitcoin loses value, so too do meme stocks.
“The impact is asymmetric, making meme stock holders’ position dangerous. They may lose money because of loss from their meme stock holdings and good performance of other speculative assets.”
With such high stakes, Shi believes that regulators play a key role in mitigating the risks faced by retail investors.
“One possible factor in the meme stock frenzy was the low interest rate. During the Covid pandemic, the central banks significantly dropped interest rates, allowing investors to finance their investments at much lower cost. I’m not saying central banks shouldn’t lower rates to stimulate economies, but when they lower rates, regulators should consider that low rates can boost excessive speculative behavior. They should urge companies to disclose sufficient and accurate information, and to identify and control rumors and fake news in popular social media, in order to cultivate a more rational investment environment for retail investors.”
Apart from meme stocks, issues around firms’ climate-related disclosures dominate other strands of Shi’s research program. As he notes in “Firm-level Climate Change Exposure and Stock Price Crash Risk,” climate-related risk has recently emerged as a positive contributor to stock price crash risk, the phenomenon whereby a firm’s stock price drops precipitously, thereby increasing investor uncertainty and the firm’s financing costs.
Against this backdrop, Shi has undertaken a comprehensive analysis of the relation between the climate-related information revealed in conference calls and future crash risk in an international context. Using a dataset that spans more than a decade and thirty-odd countries, he has found that climate-related conference call disclosures are of most value to investors in countries that are highly attentive to climate change with few regulations regarding environmental disclosure. He has also shown that such disclosure reduces crash risk regardless of whether the disclosed information is “good” or “bad” from an environmental perspective.
His latest project centers on the framework created by the Task Force on Climate-Related Finance Disclosures (TCFD) to help firms share information about their climate-related risks and opportunities. This framework will allow investors to improve the quality of their risk assessments by complementing existing reporting mechanisms: unlike current reports, which require firms to look outward to the environmental effects of their operations and practices, the TCFD requires firms to look inward to how climate change might impact their operations and financial status.
In addition to leading to the creation of a novel and comprehensive dataset, this project will examine whether and how TCFD reporting may alleviate concern about firms’ exposure to climate risk among investors and reduce the cost of equity capital for firms.
Beyond the domain of investment capital, Shi hopes that his research will inspire companies to develop innovative tools that will not only stabilize their operations, but also contribute to widespread climate mitigation and adaptation.
