Market Bubbles Cont: The South Sea Company
Hi Traders
This is the 3rd in a short series that I am posting on bubbles and crashes to illustrate that year after year crowd psychology remains the same.
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(reposted from Suite 101)
As the Harvard Business School's history of the bubble shows, the use of that monopoly was dependent on Spain's willingness to trade with England after the war. The Treaty of Utrecht, which ended the war, left Spain with full authority to regulate trade with its colonies. Spain only allowed the South Sea Company to send one ship per year to trade in South America, and that ship would have to give a quarter of its profits to the King of Spain.
1720 - Year of the Bubble
Despite this, people couldn't wait to invest in the company. The idea of a trade monopoly proved irresistible to a growing middle class with money to invest. In 1720, Parliament approved a plan to let the South Sea Company take on more of the national debt. Confidence in the company was high and stocks, which had been trading at £130 began a fast climb. As Jonathan Swift wrote of South Sea Company investors, "Here they fish for gold, and drown."
Encouraged by promises of huge profits from company officers, investors drove the stock price to £400 by April and it continued to climb. In late May the price of stock rose from £550 to £890. In August, the price touched £1000, but confidence in the company was beginning to crumble. A rumor circulated that company directors were selling their stock and pocketing the profits. The term "bubble" came into use for the first time. By the end of September, the stock was worth no more than it had been at the beginning of the frenzy and many investors were ruined.
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There were several versions of this story I could have chosen to post. Some were much longer and went into greater detail about the type of illogical crowd behavior displayed. Once again, the feeling of joining the masses outweighed common sense as people were almost fighting to buy shares of this stock when it was already pretty much proven that the company would not make money.
As you can see after several posts on bubbles, no matter what the period of time was, and no matter what the investment was, the results were the same time and time again. I am hoping that together we will explore this phenomena, to see if we can not only discover why it happens, but to see if we can develop some sort of strategy or system around it.
Cheers
Tek
This is the 3rd in a short series that I am posting on bubbles and crashes to illustrate that year after year crowd psychology remains the same.
______________________________
(reposted from Suite 101)
The South Sea Company and British War Debt
The story of the South Sea Bubble is told in Charles MacKay's 1841 masterpiece Extraordinary Popular Delusions and the Madness of Crowds. The South Sea Company, who was most responsible for the bubble, was founded in 1711 for the purpose of assuming Britain's debt, which had built up during the War of the Spanish Succession (1701-1714). In return, the company received six percent interest on the debt as well as a monopoly on trade with the wealthy Spanish Colonies in South America. Wild visions of trading English wool for Inca gold danced in the heads of South Sea Company investors.As the Harvard Business School's history of the bubble shows, the use of that monopoly was dependent on Spain's willingness to trade with England after the war. The Treaty of Utrecht, which ended the war, left Spain with full authority to regulate trade with its colonies. Spain only allowed the South Sea Company to send one ship per year to trade in South America, and that ship would have to give a quarter of its profits to the King of Spain.
1720 - Year of the Bubble
Despite this, people couldn't wait to invest in the company. The idea of a trade monopoly proved irresistible to a growing middle class with money to invest. In 1720, Parliament approved a plan to let the South Sea Company take on more of the national debt. Confidence in the company was high and stocks, which had been trading at £130 began a fast climb. As Jonathan Swift wrote of South Sea Company investors, "Here they fish for gold, and drown."
Encouraged by promises of huge profits from company officers, investors drove the stock price to £400 by April and it continued to climb. In late May the price of stock rose from £550 to £890. In August, the price touched £1000, but confidence in the company was beginning to crumble. A rumor circulated that company directors were selling their stock and pocketing the profits. The term "bubble" came into use for the first time. By the end of September, the stock was worth no more than it had been at the beginning of the frenzy and many investors were ruined.
There were several versions of this story I could have chosen to post. Some were much longer and went into greater detail about the type of illogical crowd behavior displayed. Once again, the feeling of joining the masses outweighed common sense as people were almost fighting to buy shares of this stock when it was already pretty much proven that the company would not make money.
As you can see after several posts on bubbles, no matter what the period of time was, and no matter what the investment was, the results were the same time and time again. I am hoping that together we will explore this phenomena, to see if we can not only discover why it happens, but to see if we can develop some sort of strategy or system around it.
Cheers
Tek
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Thanks for posting this Tek!
Cheers,
NoobPosted 06-16-2009 at 06:10 PM by noob_trader
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History repeats itself, just different people involved in it. It is easy to fool yourself and say that this time it's different.
Thanks for the great post.Posted 06-16-2009 at 06:41 PM by Noir
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I just downloaded the ebook at scribd.com. I've been meaning to read it for quite a while.
Thanks, Tek, for these very interesting posts.Posted 06-16-2009 at 09:04 PM by Magic
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Hi Tek
And yet another bubble, thanks for posting.
I am curious to find out why these occur.
Could it be that the social need to belong (maslow's hierarchy of needs) is so strong that when some people start doing something people others blindly follow just to feel that they are part of something and fulfill a sense of belonging? Or the fact that they don't want to take responsibility for their actions and would rather lose collectively. Maybe even if they lose collectively they still feel they were a part of the masses so it makes it more acceptable and they can still blame someone else? I don't know does anyone have any ideas?
Take care
JBNPosted 06-16-2009 at 10:47 PM by jackbenimble
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Thanks for the replies. I will be doing a couple more posts on bubbles soon, including 1990s Japan.
I am as well JBN. I find it fascinating that not only are the results the same, but the actions leading up to the results are the same as well.Quote:I am curious to find out why these occur.
I sometimes wonder if there is not some sort of subconscious part of our mind that causes us to draw into a group one way or another. If you ever work retail, you see some of this.
An example that comes to mind is working at convenience stores when I was a kid. Occasionally I would work the graveyard shift, and late at night the same thing would happen almost every day.
The store would go for long periods of time with no customers. Then, suddenly 3 cars would pull up all at the same time. It may not sound that strange here, but when you see that happen over and over again, at different stores and different times of the night, it sticks in your mind.
Add the power that money has on us, and the feeling of possibly missing out on money, and maybe it becomes like a mental magnet drawing people together
Cheers
TekPosted 06-17-2009 at 12:57 AM by Tekmnd
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Hi Tek
This sounds like an information cascade but on a smaller scale.Quote:An example that comes to mind is working at convenience stores when I was a kid. Occasionally I would work the graveyard shift, and late at night the same thing would happen almost every day.
The store would go for long periods of time with no customers. Then, suddenly 3 cars would pull up all at the same time. It may not sound that strange here, but when you see that happen over and over again, at different stores and different times of the night, it sticks in your mind.
(wikipedia)
Everyday decision-making
Benign herding behaviors may be frequent in everyday decisions based on learning from the information of others, as when a person on the street decides which of two restaurants to dine in. Suppose that both look appealing, but both are empty because it is early evening; so at random, this person chooses restaurant A. Soon a couple walks down the same street in search of a place to eat. They see that restaurant A has customers while B is empty, and choose A on the assumption that having customers makes it the better choice. And so on with other passersby into the evening, with restaurant A doing more business that night than B. This phenomenon is also referred as an information cascade.
Take care
JBNPosted 06-17-2009 at 11:22 PM by jackbenimble
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Hi JBN
This sounds like an information cascade but on a smaller scale.
Maybe; but what made them all decide to go to the store all at the same time in the first place?
(Must be "munchies cascade"
)
I see the herding part in trading. A trader will sit there watching a stock for days and not buy it at one price. Then it starts going up and they still hesitate. Finally it goes way up and they think "I better get in now or I am going to miss out."
It's like they see price going up as a graph of 'everyone else getting in on something that they fear they might miss out on.'
This can be even more so if the trader watches a basket of stocks each day as they sort of feel an emotional attachment to those stocks.
Cheers
TekPosted 06-18-2009 at 12:43 AM by Tekmnd
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Hi Tek
If a trader is having emotional attachment to those stocks well then that trader has bigger problems.Quote:I see the herding part in trading. A trader will sit there watching a stock for days and not buy it at one price. Then it starts going up and they still hesitate. Finally it goes way up and they think "I better get in now or I am going to miss out."
It's like they see price going up as a graph of 'everyone else getting in on something that they fear they might miss out on.'
This can be even more so if the trader watches a basket of stocks each day as they sort of feel an emotional attachment to those stocks.
I can relate to that gnawing feeling that you are going to miss out on. This happened to me. The last trade that I got in was because of not wanting to miss out. But why would a trader wait until it goes to the top? That doesn't make sense. The reason I got in the last trade was because I felt I was going to miss out on the ride up.
Maybe it has to do with the bandwagon effect.
Funny when the stock didn't hit the stoploss that I thought I had in place and turned around I thought good I am back on the wagon again. I got to rethink this.
(wikipedia)
Bandwagon effect, also known as "cromo effect" and closely related to opportunism, is the observation that people often do and believe things because many other people do and believe the same things. The effect is often called herd instinct. People tend to follow the crowd without examining the merits of a particular thing. The bandwagon effect is the reason for the bandwagon fallacy's success.
The bandwagon effect is well-documented in behavioral psychology and has many applications. The general rule is that conduct or beliefs spread among people, as fads and trends clearly do, with "the probability of any individual adopting it increasing with the proportion who have already done so".[1] As more people come to believe in something, others also "hop on the bandwagon" regardless of the underlying evidence. The tendency to follow the actions or beliefs of others can occur because individuals directly prefer to conform, or because individuals derive information from others. Both explanations have been used for evidence of conformity in psychological experiments. For example, social pressure has been used to explain Asch's conformity experiments[2], and information has been used to explain Sherif's autokinetic experiment.[3]
When individuals make rational choices based on the information they receive from others, economists have proposed that information cascades can quickly form in which people decide to ignore their personal information signals and follow the behavior of others.[4] Cascades explain why behavior is fragile—people understand that they are based on very limited information. As a result, fads form easily but are also easily dislodged. Such informational effects have been used to explain political bandwagons.[5]
Take care
JBNPosted 06-18-2009 at 06:09 AM by jackbenimble
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Hi again
Great stuff JBN
If you are a sports fan, you see the bandwagon effect as the team does well or poor. When the team sucks, only the true 'I love the team' fans follow the games. When the team makes the playoffs, suddenly people that hardly watch the games are suddenly wearing shirts with the team logo on it.
It has happened to me as well, and probably most other traders as well. I can think of a few things I was teetering on doing, but hesitated; buying silver is just one example. I bought a couple of silver coins for my daughter on Christmas Eve to teach her about trading. Silver was $10.26 then. I almost bought a bunch of SLV (Silver ETF) then, but thought it might drop below $10, so I waited. Right now Silver is $14.26 which is almost exactly 40% higher.Quote:I can relate to that gnawing feeling that you are going to miss out on. This happened to me.
I have had strong urges to buy silver since missing out, and I have had to fight those urges. It’s that silver is a bad buy right now; it’s that I have not analyzed for myself whether it is a good buy or not. In other words, I see the price keep going up, and without looking at charts or fundamentals to determine for myself if it is a good buying opportunity, I keep getting urges to just buy some.
I also believe strongly that there is media manipulation to play into the psychological effects of a bandwagon. As a stock or other instrument rises (or falls) the media will play into the emotional feeling that comes from this.
Some examples that come to mind are-
When oil was $140 a barrel, there were many many news reports about oil climbing to $200 a barrel. These reports came out right before oil fell to $40.
Last time gold was over $1000 an ounce, there were many many reports about gold going to $2000 an ounce. These reports came out right before gold fell to $800 an ounce.
When oil got to $38 a barrel, there were many many news reports that oil would drop to $25 a barrel. This was right before oil climbed to $50.
When houses peaked, there were reports that housing would shoot up even more to the point that people I work with were saying that if you do not buy now, you will never own a house. This was right before housing fell 40%.
This is just a couple of many examples that I could list, and I have begun to view media reports as another contrarian indicator. This is something I will be exploring in this blog.
One more bandwagon effect worth mentioning would be Beenie Babies. Remember those? For those not familiar- Beenie Babies were little stuffed animals that became the ‘in thing’ to own. Suddenly there were trading almost like a stock, and people were paying over $50 each (and over $100 for a few) for some of them. $50 for something that costs about 25 cents to make and has no real value.
I can remember 2 times it really stuck out- one time I went to the store and saw a huge line waiting for another store to open up. I thought they were waiting for concert tickets, but no, they were waiting for a new Beenie Baby to be released.
The other time was when I was channel surfing the TV and came across the Home Shopping channel. They were selling a set of 60 Beenie Babies. When I saw the price was well over $1100 I was literally sitting there for several minutes with my mouth open (Keep in mind this costs less than $20 to make). Now common sense should tell us that $1100 for $20 worth of stuffed animals that have no real value is probably not a great investment, but the crowd mentality of getting in on the hot new item trumped common sense once again.
Cheers
TekPosted 06-18-2009 at 08:35 AM by Tekmnd
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Hi Tek
I remember the Beenie Babie craze. Human behaviour is a study on its own.Sounds like a case of keeping up with the Joneses but on a smaller scale. The principle is the same though. Of course mass media has alot to do with starting information cascades and they keep fueling consumerism. They are the biggest manipulators of the masses. Probably why they say you should trade the rumor not the news.The masses trade the news. Mass media is for the masses. We are brought up to be conformists and with that mindframe it is easy for mass media to manipulate. Also when people get in the rat race the mass media keeps feeding to make sure they run faster and have even less time to think. So they got the masses where they want them.
(Wikepedia)
The philosophy of "keeping up with the Joneses" has widespread effects on society. According to this philosophy, conspicuous consumption occurs when households care about their standard of living in relation to their societal peers.[2]
According to Roger Mason, "the demand for status goods, fueled by conspicuous consumption, has diverted many resources away from investment in the manufacture of more material goods and services in order to satisfy consumer preoccupations with their relative social standing and prestige."[3]
Social status once depended on one's family name; however, the rise of consumerism in the United States gave rise to social mobility. With the increasing availability of goods, people became more inclined to define themselves by what they possessed and the subtle quest for higher status accelerated. Conspicuous consumption and materialism have been an insatiable juggernaut ever since.[4] The desire to increase one's position in the social hierarchy is responsible for much of the social mobility in America. The upward mobility over the past few decades in America is due in part to the large number of women joining the labor force. U.S. women have slowly and steadily increased their participation in the labor force from 46 percent of all women (age 16+) in 1974 to almost 60 percent in 2004.
Quote:Maybe; but what made them all decide to go to the store all at the same time in the first place?
(Must be "munchies cascade" )
Coming back to this I read it wrong. I see your point was to why they are coming to the place simultaneously. I wonder if any other members have noticed anything like this having happened? The last place I worked at I too saw this strange phenomenah occur many times over. Clients would come in bunches. It happened on a daily basis that we would say. "Oh the bus has arrived." It would go from being really quiet to really busy. I would find this so strange that I started to question clients as to why they came at this precise hour. Almost all would say that they believed that it must be a quiet and good time to come,just after the rush. Based on what rationale? I don't know. It was as if they all planned to come on some kind of subconscious level all at the same time believing that they were avoiding the rush.Then they asked me what time would be a good time to come so they don't have to wait in line. I had no clue as this didn't necessarily occur always at the same time so I told a few to call me when they wanted to come and I would tell them if it was quiet or not. Sure enough when the few did call found much to their surprise that it was quiet. Then I'd sense if they called then the bus must be on its way. Sure enough the bus would arrive. It was very weird.
Then again it could be just a coincidence and a case of the munchies.
I also find alot of the crowd psychology is also happening on smaller scales.
Thanks for posting the links.
Take care
JBNPosted 06-18-2009 at 03:50 PM by jackbenimble
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This post is very interesting. Yes, markets do create bubbles. Markets can often be irrational. Let's put our heads together and think of a way to trade the bubbles!
I think using moving averages may work well, and increase position after it breaks key resistance levels on the way up, and support levels on the way down. Just have to monitor it quick, because the bubble pops it will tumble quick.
What do the rest of you think? Any ideas for trading bubbles? Can you think of any markets right now that you think is in a bubble?Posted 06-19-2009 at 12:36 AM by mattman
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Hi mattman
I personally at this point cannot offer much insight on this as I have just started studying crowd psychology.
Reading The Crowd by Gustave le Bon - Free eBook is very insightful, It would be interesting though if one can be spotted by studying a chart. Maybe study the chart and see if there is any news being spread in the media about the stock. Maybe the two can be linked together.
Take care
JBNPosted 06-21-2009 at 01:01 AM by jackbenimble
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Hi Tek
Oops!
So that's where my first reply went. Can you please delete one of them. And no I am not trying to take up more space.
Thanks
JBNPosted 06-21-2009 at 01:21 AM by jackbenimble
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Simit's new blog is related to the bubble cycle. If you didn't check it out you may want to do so here .Posted 07-01-2009 at 12:03 AM by mattman
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