Extreme Reaction Risk

Imagine mortgaging your house to get all the money you could, selling everything else you own, and converting all your assets into speculating on the price of a single tulip bulb.

As insane as that sounds, it happened in the 17th century, not just to one person but to a spectrum of people from all walks of life. This famous example of a market mania has been called the 'tulip mania' and it had a disastrous outcome. The prices of tulip bulbs exchanged as commodities ran up to unbelievable levels when speculation fever took over and thousands of people wanted to get in on the amazing profits.
The rarity of tulip bulbs was the beginning of the problem. A seed may require 5 to 10 years to produce a tulip flower and another 3 to 5 years to work itself into a bulb. Rarity is also defined by specific color markings. In 1635, the commodity trading activity began on tulips still in the ground, and the action was done via promissory notes instead of the exchange of cash. Trading even went beyond this, with sales made for tulips that had not yet been planted. This was called a windhandel (wind trade).


Key Point

As irrational as the tulip mania was, it was not an isolated case of temporary insanity. Trading in all markets is always susceptible to manias of exactly the same kind.

Prices ran up very quickly, within less than one year, and one record-level sale involved the sale of 40 bulbs for 100,000 florin. To put this in perspective, a ton of butter was worth 100 florin at that time. Two years after it began, the bubble reached its peak and very quickly evaporated. Thousands of speculators, mortgaged and leveraged to the hilt, were completely destroyed practically overnight.

This puzzling event took place on a large scale and involved commodity prices running into outrageously high price levels. It relied on a true mania, a form of greed in which those on the outside think they are losing the opportunity to get rich like everyone else. They take risks they cannot really afford and get into the market, and the new demand creates even higher prices.

There are three issues that define greed buying like this. First, when profits look easy or automatic, logic is abandoned. People will pay anything just to get a position in the market as long as they are sure prices will keep rising. Second, speculators think the upward move will never end. And third, speculators do not set exit levels for themselves, where they will take their profits and get out. Oddly, when asked, speculators express the belief that they will somehow just know when prices are peaking. The truth is that as long as there is someone else willing to pay more, speculation looks like a game impossible to lose. But the day finally arrives when the new speculators run out. The 'greater fool theory' -- the belief that there are always plenty of people who will pay more than you did -- only works for a while.

Key Point

Greed trumps logic; it also trumps risk awareness and ultimately destroys a speculator's plan to double up and get out.

The same mentality works when markets are falling. Panic is just as irrational as greed, and traders will sell out of positions to avoid bigger losses tomorrow. The result of greed and fear is that traders may buy high and sell low instead of taking the sage advice to 'buy low and sell high.'

The greed and panic risk -- or extreme reaction risk -- can be expressed in another way: 'Bulls can make money, and bears can make money. Pigs and chickens get slaughtered.'

Tulip mania was not just an oddity that happened once 400 years ago. Similar manias have occurred throughout the history of trading in stocks and commodities, even quite recently. Between 1995 and 2000, the dot.com bubble that created the new Internet sector at one time had thousands of companies selling stock, many of which produced no products and offered no services. As many inexperienced first-time entrepreneurs became millionaires overnight based on nothing but a public offering, a growing number of others jumped onto the trend. Today, many of the most successful companies are survivors of the dot.com years, but for every success story there are hundreds of cases of people losing everything, not only in start-up offerings, but also in speculation in the stock of these new companies that have nothing in the way of assets or even products.

Key Point

The dot.com fad of recent history was just as illogical as any other mania. Traders invested fortunes in companies with no tangible assets and no product or service. It's no surprise that most of the dot.com companies are no longer around.

At various times in the history of the United States, investment crazes have occurred in real estate, cotton, railroads, canals, the auto industry, time-share computers, and biotechnology, to name only a few industries. In most of these instances, the few companies that survived produced a product that had a market, but often with too many players. For example, in 1910 there were more than 200 auto manufacturers selling cars in the United States.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

Posted in ...