The ‘tulip mania’ of Holland in the seventeenth century is an early example of investors losing out badly due to a distorted market. In this case, the price of a tulip bulb, as a form of what we would now refer to as a commodity futures contract, became ludicrously over inflated.
The increase in the price of tulips was initially rational, in that it was being driven by a genuine demand for the commodity. This increasing price led to investors speculating on the price continuing to rise. They were willing to pay a price for bulbs beyond their intrinsic value because they were confident somebody else would pay them more.
Before the bubble burst the cost of a single tulip bulb was many times what an ordinary person could hope to earn in a year. February 1637 is when the wheels came off, buyers at ludicrously inflated prices could no longer be found, and very rapidly the price of tulip bulbs came crashing back to Earth.
South Sea Company 1720
The South Sea Company was a partnership with the British state created with the intention of reducing the national debt. A company was to be set up, which would then essentially purchase debt from the holders in exchange for shares. The principle business of the company was the transatlantic slave trade.
In the case of the South Sea Company, there were some very shady practices from them in order to inflate the price of their stock. These included spreading false rumours and outright lies. The stock continued to rise until a share was worth over a thousand pounds in 1720, once this psychological barrier had been crossed investors wanted to cash out. The price rapidly collapsed.
Poseidon Bubble 1970
In 1969 the Poseiden NL mining company announced that it had found a very good site for mining nickel, leading to a sharp increase in share price. At the time demand for nickel was very strong due to factors including disruption to one of the biggest suppliers and also the Vietnam War.
Stock prices of all kinds of mining companies shot up. Unscrupulous individuals took advantage of this, listing new companies in the sector that did not even have a mining license to their name. Bad publicity from this kind of activity caused prices to fall, even for legitimate outfits.
In an ironic twist, by the time production had begun on the nickel site which started all this, prices for the metal had fallen. Ultimately it proved impossible for the company to be profitable and it went under.
Lessons to be learned
There are a few lessons for the amateur investor that can be learned from looking at financial bubbles. Anyone who is involved to any extent in share dealing or online stock trading would do well to keep them in mind.
The first lesson is to beware of misleading and fraudulent information. In the case of the South Sea Company the practice of lying to investors was endemic. There are certainly scams out there, and caution and diligence is the only way to avoid them.
Another thing to remember is that the behaviour of markets is not always rational. Investors can get caught up in the hype around an item, or can exhibit irrational optimism or pessimism, known as buyer euphoria.
Lastly financial bubbles illustrate why it makes sense to limit exposure to any given risk. A balanced investment portfolio means that an investor can weather the storm of unexpected events and bad calls.
Pamela Chimbonda writes in association with Alliance Trust Savings. This should not be considered as financial advice.