“Never underestimate the power of human stupidity”. R.A. Heinlein There are many who believe that yesterday’s markets were different to those of today. The facts, however, illustrate that markets today are just as inuenced today by human emotion as they ever were. I want to now illustrate the effect of emotion on traders with specic examples, and then analyse the lessons that we can learn. By seeing how the vast majority lose, we can hopefully step aside from the crowd and enter the elite minority who prot consistently from the markets. “Much has been written about panics and manias…but one thing is certain, that at particular times a great deal of stupid people have a great deal of stupid money… the money of these people, the blind capital as we call it, of the country is particularly large and craving; it seeks someone to devour it, and there is plethora, it nds someone, and there is speculation, it is devoured and there is panic.” Walter Bagehot - Essay on Edward Gibbon
In looking at the effect of emotions on the investing public, and excellent place
to start is with Charles Mackay’s delightfulbook “Extraordinary Popular Delusions
and Madness of Crowds” published in 1841. MacKay covers three manias we all
remember from school, The Tulip Mania,The Mississippi Madness and The South
Sea Bubble. Tulip Mania: One of the most famous manias in history occurred in Holland in the 1500s when tulips were introduced, and by 1634 they were an important fashion/ status symbol. By the time the mania had reached its height in 1636 a single bulb cost 5000 Florins or, in today’s prices, in excess of $20,000!.
“At rst, as in all gambling manias, condence was at its height, and everybody
gained. The tulip jobbers speculated in the rise and fall of tulip stocks, and
made large prots by buying when prices fell and selling when they rose. Many
individuals grew suddenly rich; gold bait hung temptingly out before the people,
and one after the other rushed to the tulip marts like ies around a honey pot. Everyone imagined that the passion for tulips would last forever, and that the
wealthy from every part of the world would send to Holland and pay whatever the
price was asked for them. Homes and land were offered at ruinously low prices or
assigned in payment of bargains made at the tulip mart. At last, however, the more
prudent began to see that this folly could not last forever. Rich people no longer
bought the owers to sell them again at a cent per cent prot. It was seen that
somebody must lose fearfully in the end and, as conviction spread, prices fell and
never rose again.” Charles Mackay
The market value of tulip bulbs declined by over 90%, and the economy of Holland
lay in ruins. MacKay concluded: “Many, who for a brief season, had
emerged from the humbler walks of life, were cast back into their original obscurity. Substantial merchants were reduced almost to beggary, and many a
representative of a noble line saw the fortunes of his house ruined beyond
redemption.” The above has very little to do with supply and demand. The trading was emotionally generated with greed and fear to the forefront. Mississippi Madness: A century after the tulip mania in Holland, it was France’s turn to experience a speculative mania. John Law, a Scotsman, who had killed his lady friend’s lover and ed to France, perpetrated this one. A gambler by nature,
he set in motion a speculative boom that became known as the Mississippi
Madness.
In 1716 Law persuaded the Prince Regan to allow him to set up a bank, and then
got the Regent’s consent to turn the bank into a Government institution. Law then
simply manufactured money, (it should have been backed with precious metals).
The abundance of money owing into the economy saw interest rates fall, and
industry boomed.
In 1717 the Crown granted Law’s Mississippi Company the exclusive rights
to trade up and down the Mississippi river. At the time, it was believed the area was awash with precious metals. The scheme caught the public’s imagination
immediately, and Law promised investors an incredible return, (with no substantiation whatsoever). Shareholders were promised a return of 120% annual
yield on dividends alone. Mackay writes: “The public enthusiasm, which had been
so long rising, could not resist a vision so splendid.”
The initial stock offering was at 400 livres in 1716 and, so frenzied was the buying, that by 1720 the stock had appreciated 40 times from the original price. Investors created a speculative bubble, ination increased and prices spiralled by 300% as successful speculators spent their paper prots. Mackay observed: “The looms of the country worked with unusual activity to supply rich laces, silks,
broad cloths and velvet which, being paid for in abundant paper, increased in price…
new homes were built in every direction, an illusory prosperity shone over the land,
and so dazzled the eyes of the whole nation, that none could see the dark cloud
on the horizon announcing the storm that was too rapidly approaching.” A leading nobleman, the Prince De Conti, started the condence collapse in Law’s grand scheme by taking three wagons of paper money to the bank and demanding payment in (spece) metal. The bubble burst as people realised they were holding worthless paper. A run on the bank occurred, and the price of Mississippi stock crashed. Shares that had soared from 500 livres in 1716 to 20,000 in 1720, plunged to 200 livres, a 99% loss. Just as the economy of Holland was devastated, so too now was the economy of France. The South Sea Bubble On the other side of the Channel, another mania was about to unfold. Robert Harley formed the South Sea Company in 1711. The company was
granted a monopoly by the Government of the day to trade with South America and the South Sea Islands. The volume of trade was unlikely to be substantial as Spain ruled most of the area and large trade, without her consent, was unlikely. However, this did not dampen enthusiasm for the company. Harley offered to absorb the national debt of over 30 million by issuing South Sea stock to bondholders. The bill passed through Parliament, and prices skyrocketed from £1281⁄2 per share in January 1720 to £1000 in August. Mackay recounts the excitement of the day: “It seemed, at the time, as if the whole nation had turned stockbrokers. Exchange Alley, (a street in the City of London), was every day blocked up by crowds and
Cornhill was impassable for the number of carriages. Everybody came to purchase
stock.”
The bubble burst in 1720 when news that the directors had been selling stock, and
panic ensued. Shares plunged from £1000 to only £135, an 87% decline. The mood at the time of the South Sea bubble fostered a rash of some of the most preposterous schemes imaginable that gripped the public’s imagination. There was, for instance, a high subscription for a company that was to manufacture a perpetual motion wheel, and another for ‘trading in hair.’ The most ridiculous of all was perhaps a company that was formed, according to Mackay “For carrying on an undertaking of great advantage, but nobody is to know what it is.” For every £2 invested, subscribers would be entitled to a dividend of £100. This unsubstantiated promise yielded £2000
within ve hours. Having made his money, Mackay commented that the promoter
“was philosopher enough to be contented with his venture, and set off the same
evening for the Continent. He was never heard of again.” “Those who cannot remember the past are condemned to repeat it.” G. Santayana
Many people would argue that we have become more sophisticated in the twentieth
century. However, the fact remains that there is no difference in the crowd psychology that became enmeshed in tulips, as today manias only differ in the degree of madness. R.E. Band, in his excellent book “Contrary Investing” llustrates the point with a company that set up in 1983 with the following in its
prospectus:
“This offering is of securities of a start up company with no operating history and
no plan of operation. The company will not engage in any business whatever until
after completion of this offering and the company does not know what business
it will engage in, and has no plan of operation.” The wording was perhaps inspired by Mackay’s eighteenth century entrepreneur. Did it raise money? Amazingly $3 million! The MMM Fiasco - A Russian South Sea
Bubble The company MMM has recently become Russia’s biggest share scandal and
has been referred to as Russia’s South Sea Bubble. The price of the stock rocketed as the company promised to pay up to 80% dividend on shares per month, or 960%
annually! The promise, of course, was totally unsubstantiated by any explanation
as to where the money would actually come from. The company reported no earnings, revealed no investments and explained no nancial strategy. The price of shares reached 125,000 Roubles, around $60, from a mere few hundred Roubles. The price was purely driven by new people buying shares. The demise of the company started with the repeated warnings from the Government, including President Yeltsin, and raids by Government ofcials for tax violations. A scramble to sell ensued and the price dropped to 950 Roubles, around 60 cents. Mr Mavrod, MMM’s charismatic Chairman,
claimed that: “We have been stopped on the eve of a super breakthrough after which Russia could have become the richest country in the world, and Russia’s MMM shareholders were wealthy people.”
How many people believed Mr. Mavrod’s empty rhetoric? The estimated gure of shareholders was disputed. Government estimates were 2.5 million, and MMM’s estimate 10 million. Whichever gure was correct, the amount of investors was considerably bigger than the Russian army and, just like the South Sea Bubble it
has been compared to, investors came from all walks of life and included many
Government ofcials. Examples of emotionally generated trading are common hroughout the twentieth century. We have the Florida land boom of the 1920s, the UK property market in the 1980s, the Silver speculators in 1980 and, of course, two major stock market crashes in 1929 and 1987. The two emotions that come to the
forefront are greed and fear. A bull market starts in a climate of fear. As the market gradually makes headway, fear recedes and condence appears as prices move
higher. Finally, as prices reach a cyclical peak, euphoria and greed take over, and
there is a consensus that the rise will continue indenitely. On the way down
the same emotions predominate, but in reverse order. The emotions of greed
and fear are the ruin of the majority of investors. “The crowd madnesses recur so frequently in human history that they must reect some deeply routed trait of human
nature…If this book showed how baseless are man’s moods of wild hope (greed), it
also showed that man’s moods of black despair (fear) are equally unfounded.
Always in the past, no matter how black the outlook, things got better...whenever
men attempt they seem driven to try and overdo.” B. Pugh
