Just imagine that you have a chance to buy for twenty-five dollars a stock whose potential earnings seem to you to justify a price of thirty dollars. Should you buy? It appears irrational not to. But wait. Suppose you also believe that the market is full of morons who will not recognize the value of your stock when you offer it for sale. “It is not sensible,” John Maynard Keynes writes, “to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe the market will value it at 20” when you decide to sell.
Keynes, as I mentioned in my last column, was not merely one of the most influential economists of the twentieth century but also a fabulously successful investor. While breakfasting in bed, he devoted half an hour each morning to the stock market—earning a fortune for himself and increasing by 1,000 percent the market value of the endowment of his college, whose investment portfolio he managed.
Keynes is associated with an approach to investing that emphasizes psychological factors—an approach memorably expressed in his statement that “nothing is more suicidal than a rational investment policy in an irrational world.” The trouble with Keynes, I thought, as I counted my losses last October 19, is that he never explains how an average member of the crowd can follow his advice, which is to “guess better than the crowd how the crowd will behave.” If you try to guess what I will do, and I try to guess what you’ve guessed, and you try to guess what I’ve guessed, and so on, it’s obvious we’re destined to exhaust one another without gaining any edge. Keynes may get rich picking stocks while he sips tea in bed, but you and I probably will have to keep on working.
One reason it’s so hard to outguess the crowd is that the crowd goes crazy now and then. When that happens, investors reach for Mylanta, and business journalists reach for Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds.
Mackay, a British journalist and poet, published the book that keeps his name alive in 1841, at the age of twenty-seven. For readers interested in financial panics, only the first hundred pages of the big book matter. Here Mackay offers detailed accounts of three of history’s most glorious speculative bubbles. The last six hundred pages furnish a miscellaneous collection of chapters in “the great and awful book of human folly": “The Alchymists,” “Modern Prophecies,” “Fortune-Telling,” “The Magnetisers,” “The Witch Mania,” “Haunted Houses,” “Relics,” and so on.
Unquestionably the most memorable chapter in Extraordinary Popular Delusions is Mackay’s account of the tulip mania that hit Holland in the 1630s.
At the height of the madness, Mackay reports, a single root of the rare species viceroy was traded for two loads of wheat, four loads of rye, four fat oxen, eight fat swine, twelve fat sheep, two hogsheads of wine, four tuns of beer, two tuns of butter, one thousand pounds of cheese, a complete bed, a suit of clothes, and a silver drinking cup—the whole valued at twenty-five hundred florins. An even rarer root was purchased for forty-six hundred florins, two gray horses, a complete set of harness, and a new carriage.
Some unfortunate mishaps occurred. Once a grateful merchant treated a sailor who had just returned from a long voyage to a fine red herring for breakfast. Seeing a bulb that resembled an onion near him, the sailor ate it with his herring, only to learn that “he had been eating a breakfast whose cost might have regaled a whole ship’s crew for a twelvemonth.” No longer grateful, the merchant filed charges that sent the sailor to jail for months.
The bubble swelled. Prices kept rising, propelled by the fatal optimism that fuels all manias. Few people were immune. “Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney-sweeps and old clotheswomen, dabbled in tulips. People of all grades converted their property into cash, and invested it in flowers. Houses and lands were offered for sale at ruinously low prices, or assigned in payment of bargains made at the tulip-mart.”
At last the bubble burst. As a fever of greed had swept through the crowd, now a fever of doubt swept through it. Prices plunged. Families were ruined. “The cry of distress resounded every where, and each man accused his neighbour.” Holland spun into a depression that lasted for years.
Mackay tells the story of “The Tulipomania” in nine vivid pages. He also offers longer, less memorable accounts of two linked manias that occurred nearly a century later—the Mississippi and South Sea bubbles of 1720.
The Mississippi Bubble is worth remembering’if only because it introduces us to one of those extraordinary minor figures who make history so much fun for the general reader. Born in Scotland in 1671, John Law fled to the Continent at twenty-six after killing a man in a duel over a woman. There followed a long period of restless roaming, during which Law supported himself by gambling and won a reputation as “one better skilled in the intricacies of chance than any other man of the day.”
Law learned much about trade and became convinced that paper currency is the key to national prosperity. In France, after the death of Louis XIV in 1715, Law persuaded the duke of Orléans, who ruled as regent, that he should be allowed to establish a bank authorized to issue paper money.
The early success of the bank led the regent to the lamentable conclusion that “if five hundred millions of paper had been of such advantage, five hundred millions additional would be of still greater advantage.” Law almost certainly knew better, but “with a weakness most culpable,” he did not resist.
In 1717 the grateful regent gave Law permission to establish a company that would have the exclusive privilege of trading to the lower Mississippi Valley. To this privilege was added, in 1719, the exclusive privilege of trading to China, the East Indies, the South Seas, and all the possessions of the French East India Company.
Law’s Mississippi scheme turned into the Mississippi Bubble when the public, stirred by Law’s promise of spectacular dividends, lashed itself into a bidding frenzy in response to an offer of shares in the venture. Infatuation and folly are the dominant words in Mackay’s account of this process.
In one of the most striking passages in his book, Mackay compares the financial edifice that Law created, resting on its twin pillars of worthless currency and wild speculation, to the “gorgeous palace” erected by the Russian prince Potemkin to impress his mistress: “huge blocks of ice were piled one upon another; Ionic pillars of chastest workmanship, in ice, formed a noble portico....but there came one warm breeze from the south, and the stately building dissolved away....So with Law and his paper system. No sooner did the breath of popular mistrust blow steadily upon it, than it fell to ruins, and none could raise it up again.”
Law fled from France with the clothes on his back and one diamond, “the sole remnant of his vast wealth.” He died in Venice in 1729. Noting that Law invested none of his fortune outside France when he might easily have done so, with the result that he left the country “almost a beggar,” Mackay comments, “This fact alone ought to rescue his memory from the charge of knavery...”
No one has wished to rescue the memory of the perpetrators of the South Sea Bubble, which was a straightforward swindle inspired partly by the wish to slow the flow of capital from Britain to Paris in the days before Law’s Mississippi scheme collapsed.
Formed in 1711, the South Sea Company was granted a monopoly on South Sea trade in 1720 in return for assuming three-fifths of Britain’s national debt. The plan was passed over the opposition of the Whig leader Robert Walpole, who warned that its advocates intended “to raise artificially the value of the stock, by exciting and keeping up a general infatuation, and by promising dividends out of funds which could never be adequate to the purpose.”
In the speculative binge that followed, “every fool aspired to be a knave,” but many remained fools. The trade in shares of the South Sea Company could not quench the “thirst of gain” that burned in every throat. Hundreds of joint-stock ventures were formed to take advantage of a public that thought stock prices must rise forever.
These ventures included one for “trading in hair” and one for “extracting silver from lead.” One million pounds were subscribed for a perpetual-motion machine. Best of all was “a company for carrying on an undertaking of great advantage, but nobody to know what it is.” One thousand subscribers paid two pounds each as a deposit for shares in this venture, whose originator pocketed the money and promptly absconded for the Continent.
Some of these enterprises ran through their life cycles in a fortnight or less, and so they came to be called bubbles. When at last confidence collapsed, the public turned furiously—and with good reason—against the directors of the South Sea Company, one of whom was the grandfather of the great historian Edward Gibbon. “Nobody blamed the credulity and avarice of the people...or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors.”
In his preface to the edition of Extraordinary Popular Delusions published in 1852, Mackay squeezed his book into a single sentence: “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, and one by one.” Both the buying spree that pushed the Dow Jones Average over twenty-seven hundred in 1987 and the selling panic that pulled it down 508 points in a single terrifying day seem classic instances of “going mad in herds.” If, as I write this, we appear to have recovered our wits, we can be confident that we have not recovered them for good. That’s a point to keep in mind the next time your broker calls with a hot tip on tulip futures.