It was 170 years ago when Scottish journalist, Charles Mackay noted:
We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first.
When people think about really, really ridiculous bubbles, the Dutch Tulip bubble of 1636 instantly should come to mind. It’s generally considered the first recorded speculative bubble.
Source: Wikipedia (click for larger image)
How did people even get excited about tulip bulbs!?
Tulips came completely out of nowhere, having been imported from Turkey in 1554. The tulip was different from every other flower known to Europe at that time, with a saturated intense petal color that no other plant had. They blew everyone’s mind, and ownership of them became a major status symbol for the elites.
As the flowers grew in popularity, professional growers paid higher and higher prices for bulbs, and prices rose steadily. By 1634, in part as a result of demand from the French, speculators began to enter the market. Soon after, the Dutch created a type of formal futures market where contracts to buy bulbs at the end of the season were bought and sold. The Dutch described tulip contract trading as windhandel (literally “wind trade”), because no bulbs were actually changing hands.
By 1636, the tulip bulb became the fourth leading export product of the Netherlands, after gin, herrings and cheese. The price of tulips skyrocketed because of speculation in tulip futures among people who never saw the bulbs. Many men made and lost fortunes overnight.
People were purchasing bulbs at higher and higher prices, intending to re-sell them for a profit. Such a scheme could not last unless someone was ultimately willing to pay such high prices and take possession of the bulbs. In February 1637, tulip traders could no longer find new buyers willing to pay increasingly inflated prices for their bulbs. As this realization set in, and buyers refused to show up to routine bulb auctions, the demand for tulips collapsed, and prices plummeted—the speculative bubble burst. Some were left holding contracts to purchase tulips at prices now ten times greater than those on the open market, while others found themselves in possession of bulbs now worth a fraction of the price they had paid.
Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favoured clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clotheswomen, dabbled in tulips.
– Charles Mackay
The ensuing rapid ascent of tulips became the very definition of the ‘greater fool’ theory in action.
Whether it’s tulips, property, stocks, weed, Beanie Babies, or Bitcoin (crypto), bubbles have been growing and popping for centuries, as far back as 1637 in the case of Tulip Mania. Since then, mainstream media has had a terrible track record of identifying bubbles accurately, and in real time. In fact, it’s probably quite the opposite.
Will we see another bubble in financial markets? Sure we will – I guess we won’t know it was a bubble until after it’s popped. Here are some of the greatest bubbles in financial history and their relative magnitude to each other.
Financial bubbles completely change the way certain investors approach financial markets and investing. I also believe some investors forget the main lessons of financial bubbles far too quickly.
Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.
– Charles Mackay
Here are four tips to avoid a bubble:
- Don’t mind missing the party. The music always sounds good, until the police raid the joint. If something feels wrong, don’t join in just because it looks like everyone else is having fun.
- Focus on your objectives. Don’t get sucked into playing someone else’s game. If you focus on investing to meet your needs and circumstances, you will be less inclined to follow the crowd.
- Diversify. It is one of the most basic of investment principles, but one that people abandon too readily. If you spread your investments out sufficiently, you will minimize the impact of any one bubble bursting.
- Have an exit strategy. When you buy something, have a predetermined exit strategy. That way, if you are fortunate to see your investment go up, you won’t get drawn into holding on just because it seems to be getting more popular.
- Rebalance. This will help you execute tactics 3 and 4: As individual investments or asset classes rise, periodically trim them back to keep them in line with your planned mix. That way, a bubble won’t inflate an investment to the point at which it has an oversized impact on your portfolio.
Don’t say I didn’t warn you.
Source: Business Insider, Wikipedia, Forbes