What can we learn from some of the biggest market bubbles in history?
Strike up a conversation about investing in the stock market and it will almost inevitably circle back around to economic bubbles.
Nobel Prize-winning psychologist Daniel Kahneman once theorized that, “The brains of humans contain a mechanism that is designed to give priority to bad news.” Just take a look at any news channel today and you’re bound to agree.
Humans are obsessed with bad news. This might have the benefit of making us more cautious, but it also means that we tend to focus more on the potential negatives of any venture—even if they are heavily outweighed by the positives.
Not a bad thing, you might say, but not necessarily a good thing either.
I’m a big believer in the learning opportunities provided to us by retrospect. We’ll never be able to predict the future. Having a good understanding of past events will help us to prepare a little better though.
With that in mind, let’s take a quick look at some of the biggest market bubbles in history to see what we can learn from them…
Dutch Tulip Mania
Widely considered as one of the first economic bubbles, the Dutch Tulip Bubble was about as crazy as the name suggests…
The present-day Netherlands is synonymous with tulips, but that wasn’t the case in the 16th century. In fact, the tulip wasn’t introduced to the region until about 1593 by the botanist Carolus Clusius, who brought a small quantity back with him from the Ottoman Empire (present-day Turkey).
But what the Dutch did have at the time was money… and lots of it. In fact, the area that was then known as the United Provinces was actually the richest region in Europe.What do rich people do when they have money burning a hole in their pocket? They buy stupid stuff. Click To Tweet
The rare flowers Clusius brought back with him were beautiful. Some, however, were made more even attractive thanks to a strange, flame-like, pattern of color on their petals (tulips are naturally monochrome). This has since been attributed to a disease in the plant known as ‘cultivar’, but at the time, it made a rare plant all the rarer.
Tulip plants exhibiting ‘cultivar’ became highly sought after by the upper classes, who began collecting them. As predictably happens with these situations, others noticed the increasingly high prices being paid for these plants and wanted in on the action. Large quantities of tulip bulbs were bought up by private buyers, reducing the supply and driving the price up further.
Of course, because they were buying bulbs instead of plants, there was no way to be certain that the tulips would even exhibit the ‘cultivar’ pattern. In a way, it was probably the birth of speculative trading!
By 1623, it was reported that as much as 12,000 guilders were being offered for just 10 bulbs—the same price as a townhouse in the middle of Amsterdam. According to some sources, the prices jumped twenty-fold in one particular month. Historian Mike Dash wrote that by 1637, the price of one bulb was, “enough to feed, clothe and house a whole Dutch family for half a lifetime, or sufficient to purchase one of the grandest homes on the most fashionable canal in Amsterdam for cash.”
Peak tulip mania hit in the winter of 1636-1637, but it all came crashing down the following February. A few savvy dealers decided to sell, and as the price started to fall, people suddenly realized that they had put their entire life savings into the fortunes of a plant. Almost overnight, the value of tulip bulbs dropped as much as 90%.
Over the next few months, tulip debts were left unpaid and many individuals faced financial ruin. The government of the time even stepped in and offered to honor 10% of outstanding contracts. In short, the richest country in Europe ended up sinking into a deep economic depression, all because of a plant.
The South-Seas Bubble
Established in 1711, the South-Seas Company was a British shipping company that intended to monopolize the lucrative trading routes of the Spanish colonies in South America. However, with the War of Spanish Succession raging at the time (which would decide the future control of these colonies), the fate of the company depended on a favorable outcome for the British.
Peace treaties were eventually signed in 1713. However, they confirmed the Spanish empire’s sovereignty over the lands it had conquered in South America, which severely limited the scope of British trading opportunities in the region.
Still, the South-Seas Company had already agreed to take on a portion of the British national war debt in exchange for the promised monopoly of the region. More and more national debt was assumed by the company over the next few years, despite the limited success of the trade missions they made.
Of course, the lack of actual success was skilfully counteracted by fanciful tales of adventure and success spread by the company, not to mention the enduring promise of mountains of gold and silver just awaiting transportation back to the empire. 18th-century marketing, if you will.
Investors flooded in. In January 1720, shares in the South-Sea Company were reportedly trading at £125. By the end of March the same year, they were up to £330. Remember, Britain was one of the largest empires on earth for some time at this point and investors saw no reason to doubt the success of trading missions. However, actual trading operations were not matching the price of shares, which peaked at £1050 in June of 1720.
The booming fortunes of the South-Seas Company shares also sparked a host of other ventures going public in the hope of capitalizing on investor optimism. Business proposals included improving the art of making soap, developing a wheel for perpetual motion, and the transmutation of quicksilver into a malleable fine metal… whatever that means.
The collapse, when it came, was brutal. Management realized how precarious things had become and sold off their shares first, hoping that others wouldn’t notice the large bubble in the room. Of course, bad news doesn’t take long to spread, and by September the share price had tumbled back to £125—less than an eighth of what they were once worth. Other companies that had sprung up off the back of the investor optimism, along with some other well-established ones, collapsed in sympathy too.
Even Sir Isaac Newton, one of history’s most influential thinkers, lost his fortune in the collapse. His famous quote, “I can calculate the motion of heavenly bodies, but not the madness of man”, makes a little more sense now…
Both company and government officials were exposed for their web of lies and deceit in the wake of the collapse. The fallout was so great that the British government actually went as far as to outlaw the issuing of stock certificates for more than a century afterward.
The Stock Market Crash
It remains one of the most famous market collapses of all time, but what exactly caused the Stock Market Crash of 1929?
In post World War I America, things were looking decidedly up. The country had rapidly become a global superpower and super-charged industrialization meant that almost everyone was getting richer. These levels of industrial growth also meant that the markets were booming. Investing in the stock market was pretty much a win-win situation. No wonder it was called the ‘Roaring Twenties’.
But with a flood of new investors entering the market, the scene was also ripe for manipulation and downright swindling. The ‘pump and dump’ was widespread. Experienced traders would invest heavily in a company to boost its share price. This would attract inexperienced investors, who assumed a rising share price could only be good. Once these new investors had put their money down and further inflated the price, however, the original investors quickly sold off all of their shares for a tidy profit.
It’s important to note that if these novice investors were so eager to jump in immediately when they saw an ascending share price, they were also much more likely to panic when it declined.
By the time the bull market peaked in 1929, the American economy was actually in decline. Production and employment had fallen, meaning that the precarious heights the stock market had risen to was being propped up by a weakened economy.
On October 24th, 1929—the day now known as Black Thursday—panic began to set in as more than 12.9 million shares were traded—a record at the time. These losses were tempered somewhat the next day as investment companies and banks bought up large holdings in an effort to stabilize things. But when the markets opened on the Monday, they went into freefall.
Over the four days of the Stock Market Crash, the Dow Jones lost the equivalent of $396 billion. That’s more than the total cost of World War I.
It didn’t end with just the crash, though, as the country then fell into the Great Depression which essentially lasted right up until the start of World War II.
So what can we learn?
We might scoff at the mistakes of past investors, but a lot of the principles of successful investing that stand true today would have been useful back then.
For instance, during the Tulip Mania, people invested heavily in the predicted outcome of bulbs which may or may not have displayed the ‘cultivar’ pattern. They were essentially risking their life-savings on pure speculation.
More importantly, however, was the actual commodity they were investing in. Warren Buffett has famously never warmed to gold because it lacks utility. Gold will never produce anything and is at the absolute mercy of public opinion. Though tulips can be more or less produced on demand, they possess that same lack of a fundamental utility.
Think about the very public flops of some high-profile companies in today’s market and you can see that investors are still being duped like those in the South-Seas Company. For all the public declarations of confidence by CEOs and marketing gimmicks, a company will essentially live or die by its balance sheet. Make sure you’re not caught up in the hype.No matter how positive a company's outlook might seem, the balance sheet must back it up. Click To Tweet
And finally, take some time to invest in knowledge before investing with cash. We’re currently in the midst of one of the longest bull markets in history. Take some time to study the fundamentals of investing, and then take some more time to study companies before you invest.
Though it may not have the same severity as the 1920s, a downturn of some degree is inevitable. We don’t know when exactly it will be, but those who have invested in great companies that have been properly researched will have less to fear.