Investment Manias and Speculative Bubbles




 Jonathan Myers






It is the investment bubble that speculators rise on. Bubbles form because of crowd behavior and the snowball effect. As investors place more and more money into one particular investment, the price rises sharply. There is no relationship to fundamental valuation and as a result, the bubble can burst just as quickly as it formed.

Once a bubble exists in the market it can cause ripples that do more than just inflate investor perception, where one investor causes others to act in concert towards psychonomic breakdown. As over-investment increases, companies themselves begin to perceive their financial situation differently; believing, for example, that they’re making more efficient use of their capital than if they chose an investment elsewhere with equal or less risk or indeed, their high market price reflects their asset value.

Lenders may also misperceive a company’s financial strength and be more inclined to make loans. It’s not simply a delusion but an example of belief anchoring, where escalating comparisons are made based on the perceived financial status of other companies. In a sense, generalized thinking moves up a notch. This is one of the reasons why the Asian markets fell during October 1997. Hence, when the bubble bursts, the snowball effect goes into reverse with investors highly overextended and unable to meet their payment schedules. And when they default, not only is it felt in their sector but also in other sectors, such as banking and finance. Yamaichi Securities, a major finance house, was only one of the players that got bloodied during this period. As the ripple spread, J P Morgan and a host of other institutions with interests in South East Asia, felt the shock wave. At the extreme, whole economies are affected. The entire structure is like a house of cards and when it falls, it falls hard.

There is no doubt that it is mania that causes bubbles to inflate. And once the herd is moving, psychonomic momentum - where personal internal biases interact with the external market and the biases of its constituent investors - rapidly picks up in a self-reinforcing manner. But how do bubbles pop into existence in the first place? To throw some light on this, let’s go back in time to see some remarkable examples.


Tulip mania

It is often the scarce which is prized the most. At the end of the 16th century, the tulip was first introduced from Turkey and soon became a popular flower throughout Europe. In Holland, particularly, the tulip rose to prominence when wealthy Dutchman bought them as a status symbol; much like owning the latest, fast car or a set of designer clothes, is a sign of prestige today.

Things would have stayed relatively quiet in this area except for the fact that a virus suddenly descended on the tulip bulbs. This didn’t hurt the bulbs but had the effect of producing colorful variations in the next generation’s petals. Demand increased astronomically and Dutch flower producers and merchants found it difficult to keep up with orders.

In an attempt to control the supply of the new tulips and make some money, the merchants realized that pre-ordering the bulbs from the growers at the beginning of the planting season, or sitting on them for a while after delivery at harvest time, gave them a guaranteed profit when they sold. And that is when the price of the bulbs began to rocket. By 1634 everybody was speculating in tulip bulbs and the bubble was growing.

During the next two years, the bulb growers covered every angle and there were tulip bulb investments for everyone’s taste. The most common was the Gouda, which doubled in value to three florins; a craftsman would earn this in about a week. The Centen rose from forty to three hundred and fifty florins; the value of a small house. And the rare Semper Augustus rose to 6000 florins; the equivalent today of about $820,000.

The word spread fast amongst the crowd that unimaginable gains could be made. And where there’s money there are salesmen. They traveled round the country from village to village selling a variety of tulip investments to local people, who would often pawn their family heirlooms or mortgage their farms. There were tulip auctions where the prices of bulbs were bid up to stratospheric heights. And taverns organized discussion evenings where people could talk about tulips and the trading that went on in Amsterdam.

By the end of 1636, it seems that the Dutch population had gone tulip crazy, believing that what had previously risen would continue to rise. But, prices bore no relationship to the real worth of a tulip bulb - even though it could be argued that the bulb had potential profit built in because it would be the progenitor of future generations of flowers and more bulbs.

With the mania at its height - and terrible timing - Dutch government officials stepped in to dampen the market, believing that the wild speculation was a threat to the economy. On the 2nd February 1637, this action sparked a turn in prices. With their finger on the pulse of the market, the Dutch merchants decided that it was time they realized some of their profits and began to sell off their stockpiles of tulip bulbs. Within two days, the bubble burst and the market in tulip bulbs crashed.

This was inevitable as the people who were speculating had little interest in the tulips. These speculators simply wanted to buy the bulbs so they could eventually sell them at a higher price.

All items and commodities have an intrinsic worth, but all that was supporting the market price was a false belief that the bulb would continue to be worth more than it was the day before. As with all collectible items, such as rare stamps or wine - or even property - the price must bear some connection to reality. While pretty the tulips may have been, real collectors had long since removed themselves from the insane fray. So, as the support was purely a psychological phenomenon based on greed, when this disappeared, there was no reason anymore for people to buy tulip bulbs. In spite of assurances from the Dutch government, fortunes were lost as overreaction and panic now replaced rationality and the country fell into depression.

Did investors learn the lessons of history? A little over eighty years later another bubble craze would inflate speculative investment to unprecedented heights.


The South Sea bubble

The South Sea Company, formed by John Blunt and his associates in 1720, proclaimed with ‘confidence’ that it would fund the UK’s national war debt, amounting to around thirty one million pounds. Its business would be in trade goods, such as wool and cotton, and its markets would be in South America and the Latin countries. The likelihood of success was promoted on the basis of better political relations with Spain, due to a relatively quiet interval after years of periodic conflicts amongst various European countries. Trade routes would, therefore, open to this area of the world administered by Spain and the formation of trading links could begin. It all appeared plausible and a marvelous opportunity that shouldn’t be missed.

The people liked the concept and so did the British parliament, who promptly passed a bill giving it their formal approval. The stock, previously at one hundred and thirty pounds, was now worth three hundred pounds.

It seemed too good an opportunity to miss and investors wanted more. From George 1st and leading members of government down to ordinary people. So, the company issued more stock… and more stock… and more stock. There was even an installment plan. Ten percent was required as a down-payment and the rest could be paid a year later. The price eventually peaked at one thousand pounds a share. Then, the bubble burst.

A recipe for disaster in the making? Perhaps. But, the end appears to have been precipitated by the directors themselves. They knew full well that the value of the company bore no relationship to its fundamentals and they quietly began dumping stock. News and rumor has a way of spreading and becoming public. The secret got out and as investors sold heavily, panic swept through the market, driving the price down through the floor. And that was the end of the South Sea Company.


Where there’s one bubble, there’s another

In 1849, Charles Mackay’s Extraordinary Popular Delusions and The Madness Of Crowds chronicled these events and showed how readily investors became caught up in bubbles. With almost daily regularity, hundreds of companies sprang up in the footsteps of the South Sea Company. Only later, after much damage, were they deemed illegal and abolished by government.

During this legendary period, the streets of London were hit with an avalanche of eager investors from all walks of life, all looking to get rich quick. The fraudsters of the time realized how easy it was to manipulate the crowd and stepped on the bandwagon with their own versions. They, more than anyone else, knew that the craziness that dominated the market could be exploited. Investors were falling over themselves with greed and avarice and determined to speculate their money. All that was needed was a place to put it and all the schemes and scams that sprung into existence, obliged their manic desire.

One famous verse of the time encapsulates the mood:


"Our greatest ladies hither come

And ply in chariots daily

Oft pawn their jewels for a sum

To venture in the Alley.

Young harlots too from Drury Lane

Approach the Change in coaches

To fool away the gold they gain

By their obscene debauches."


Few other episodes better describe the mentality of the day than the company that issued its prospectus: ‘…for carrying on an undertaking of great advantage but nobody to know what it is.’ On the day of the issue, over a thousand investors scrambled excitedly to get ahead of each other in the line to purchase stock in the company. By mid afternoon, with interest beginning to subside, the fraudster who’d dreamt up the scam had taken all the money and disappeared.

Here is a selection of the more outlandish schemes that sought investment funds. Their proposals described their aims as being for:


  • Trading in hair
  • Insuring and increasing children’s fortunes
  • A wheel of perpetual motion
  • The transmutation of quicksilver into malleable fine metal
  • Trading in and improving certain commodities of the produce of this kingdom and commonwealth
  • Extracting silver from lead
  • Insuring to all masters and mistresses the losses they may sustain by servants
  • Importing jackasses from Spain


Mackay understood the hysteria of the crowd and his work centers on how this behavior, so senseless, is transmitted from one investor to another. He wasn’t alone, satirists and print-shops of the day did an excellent business selling drawings, rhymes and cartoons, ridiculing the folly of speculators who follow one another towards financial ruin.

One resourceful printer produced a pack of South Sea Bubble Cards with a caricature of the bubble company and a humorous verse below. One of the funniest - although not funny to those who invested their money - was Puckle’s Machine Company. Its advertising proclaimed its purpose as being: ‘….for discharging round and square cannon-balls and bullets and making a total revolution in the art of war.’

The verse on the eight of spades read:


"A rare invention to destroy the crowd

Of fools at home and fools abroad

Fear not, my friends, this terrible machine

They’re only wounded who have shares therein."


While the nine of hearts, with a caricature of the English Copper and Brass Company, had this verse:


"The headlong fool that wants to be a swopper

Of gold and silver coin for English Copper

May, in Change Alley, prove himself an ass

And give rich metal for adulterated brass."


According to Mackay this was no small-scale pastime for those who wanted to get rich quick by starting bubbles. The total amount invested in the various schemes he estimates to be above three hundred million pounds. For the years in question, during the 1700’s, that’s no small sum.


We’re far more experienced now - aren’t we?

These historical, financial events are some of the most colorful ever recorded. Perhaps the reason they occurred with such dramatic consequences is that the markets were still in their infancy. Overall, it forced the professionals and politicians of the day to face the realities of a market system and the need to change practices and introduce safeguards.

But if you think that this century has escaped by good sense and experience, well, here’s just a sample of speculative bubbles to hit markets around the world, with the approximate year their cycle began.


  • Florida real estate - 1923
  • Stock market speculation - 1923 (ending in Wall Street crash 1929)
  • Gold - 1978
  • Rare stamps - 1979
  • Japanese equities and property - 1982
  • Jojoba bean - 1985
  • UK housing - 1986
  • New stock issues - 1986 (ending with crash of Black Monday, October 1987)
  • Lloyds Insurance underwriting - 1988
  • Emerging Asian markets - 1991 (ending with global market correction, October 1997)
  • New issues/Initial Public Offers of Internet companies - 1995


This last speculative craze to hit the market represents one corner of the technology sector that appears to currently hold a fascination for investors. If a company is connected to exciting, cutting edge research in biotechnology, medicine, computing or electronics, there’s a steady flow of enthusiastic buyers.

During 1995 and 1996, the whole Internet sector was buzzing and new stock was being snapped up before the IPO application forms had even hit the doormats of prospective applicants. These new companies then proceeded to make some of the most spectacular gains the market had ever seen. Yahoo, for example, was issued in April 1996 at $13. It opened on its first day of trading in the market at $24.50 and continued rising to $43. This represented a gain of 231 percent, with the stock trading at 77 times predicted earnings for 1997.

Was it sustainable? Many financial experts thought so and fuelled the risk-taking binge, promoting these speculative stocks even as the bubble expanded. The attitude was: Like the railroads of a century ago created change, these are innovative companies responsible for the coming revolution in the way we live and work, and so important that they must form part of a comprehensive investment strategy. Emotive stuff for sure and with sector prices scaling new heights every day, and the general publics’ eagerness to buy technologically driven companies, the brokers didn’t have to try too hard.

At the same time, however, reality was beginning to rear its head. There was uncertainty about achieving the physical internet hook-up of users to access all the commercial possibilities; no one knows what the Internet’s ultimate potential is; and so far, many of these companies suffer from a serious lack of earnings, as well as needing to sustain a massive capital outlay for an increasing customer base. Several months later, matters came to a head as short-term investors began bailing out. Yahoo slid to $28, while other Internet companies fared worse. CompuServe, for example, issued at $30, had reached a high of $36 and then fallen back to $9; an overall loss, to any unlucky buyer who entered the market at its top, of 75 percent.

Nevertheless, however crazy this market is, for those who bought the initial Yahoo issue, and recently sold at the height of the US bull run, a handsome profit’s been made. At $148 this represents a gain of 1,038 percent - although it’s since dropped to $118 during October 1998, along with the falling market. But the question is: how many people sold out their positions or, are still invested in the hope – justified or not - that Yahoo will go higher?

Human nature being what it is the crowd will move again. There is no doubt of this as the attraction of easy wealth exerts a seduction that few speculators can resist. Therefore, there will be more investment bubbles; we cannot predict where or when but they will come.


Manipulating the bubble

The lure of incalculable riches can make investors follow the crowd in a different way. Get rich quick schemes can be very attractive to the unwary. With their efficient glossy advertising, hotel conventions, and the testimonials of previous successful investors - at seminars, on TV - it’s easy for the uninitiated to get swept along on the euphoria generated. In effect, this produces, a mini bubble. Few, pause for thought once that germ of greed is planted, believing that with ease, they too can become just as wealthy as the individuals held up as prime examples. In a room full of people, or even reading the companies slick brochures, the effect is contagious. It’s like the cartoon character who’s eyes suddenly depict large Dollar symbols when he opens a treasure chest full of gold and precious gems. As a result, you become gullible as your financial realism and good sense gives way to baser desires.

But again, there’s folly in the behavior of the crowd. In 1995, the UK’s Securities and Investment Board examined over five hundred major cases where investors lost money in speculative schemes. Around the world, the story is the same. Any illegality is obviously a matter for criminal investigation and, of course, investors need to be protected from the sharks. But, as you’ll see, it’s not always so simple. For one thing, if investors willingly hand over money and it disappears, compensation is not always possible.

Responsible investment means becoming aware of when someone’s taking advantage of you. Your mindset can be changed so that others can’t influence you against your will. The deeper psychological reasons why investors are gullible and keep on getting ripped-off, we’ll see in the next chapter. For the moment, on the assumption that forearmed is forewarned, take a look at some of the best known schemes that repeatedly pop up in different forms. These include: pyramids, sell and store, and pump and dump.


Pyramids - it’s not just ancient Egyptians who build them!

Pyramid schemes are some of the most commonly investigated speculative investments. They depend on investors recruiting more investors and often, it’s someone you know who knocks on your door telling you about this great business they’re in. And once the news is out that there’s profit to be made, the herd begins to move. There may or may not be a product but in the long run this doesn’t matter because the aim of the company behind the scheme is to gain new investors in a never ending cycle. The promise alone of future high investment returns is usually sufficient to prompt you to join.

There are two forms of pyramid scheme: one is a scam, the other is likely to lose you money but is not illegal. With the scam, the company is completely aware that its product or service cannot produce the advertised returns. Sometimes known as a ponzi scheme, it is illegal, but continues to entice investors to sign up with the same unfounded promises. Each time a new investor joins, new money is brought in that goes to pay off previous investors and generate a commission for the directors. When the pool of new investors dries up, the pyramid becomes unstable. Hence, someone is not going to get paid. At this point, the directors collect their cuts and take a plane trip to the Bahamas!

The more legitimate form is where the company appoints agents to sell a product and introduce more agents. Each time, a commission is generated and passes up to the top of the pyramid. In reality, the product is not what the company is selling. It’s selling agencies. Anything an agent sells, from water filters to pet insurance, is extra commission for the directors.

Take the case of Dan Furnley, who decided to invest in ostrich farming. ‘For £12,000 you too can be the proud owner of an ostrich,’ said the advertising literature the company sent. It went on to state how, after the breeding season a few months later: ‘Your ostrich could produce up to forty chicks, which at current market prices can each be sold for £500.’ The company behind the scheme, the Ostrich Farming Corporation, also guaranteed an annual fifty-percent return and even promised to buy back the chicks if other buyers couldn’t be found. ‘Don’t forget,’ said OFC, ‘the demand for ostriches is about to soar as consumers discover ostrich meat.’

Sounds too good to be true? The Department Of Trade and Industry in the UK thought so too after receiving complaints from a number of disgruntled British investors. After investigating, the DTI concluded that, ‘Pigs or ostriches might fly!’ It wasn’t so much that they were unhappy about ostrich farming but based on their knowledge of the market in legitimate ostrich farming, the DTI believed that the only way OFC could honor its claims was by selling more ostriches to more investors rather than the returns generated from the ostriches themselves.

Eventually, OFC were shut down. But not before Dan Furnley and a great many investors eager to make a fast profit, had ploughed hundreds of thousands of pounds into the scheme.

As Dan later explained when he spoke to his accountant about the loss he’d made, ‘The problem is, it’s so easy to believe your going to make money from these types of investment. All you have to do is make a one off payment and sit back as your ostrich starts to produce valuable chicks.’

But it wasn’t just the prospect of little tiny ostrich feet that was the attraction. As an added incentive, when the opportunity to present new investors to the company comes along, you get to take a commission to sweeten the pot. And as each of your recruits, recruits more investors, you even get commission on their commission and onwards down the line. It’s like a chain letter with a little gift to you each time the letter is forwarded.

These are the classic methods by which pyramids operate. A little psychological reinforcement to reward good performance, while an increasing commitment spurs you on to work even harder. The work you’re doing may actually be out of proportion to your profit from the scheme but once you’re hooked in to that cycle of behavior, it’s incredibly difficult to break free. Investors will even justify their actions to themselves and others. For example: I’m not yet working hard enough to gain the full profit as others higher up the pyramid or, I just need better sales leads, and so on.

Eventually, the levels of new investors increases dramatically, with each level passing money back up to the top of the pyramid. Those sitting there have to do very little work and have their own personal goldmine, while those further down have to work harder to gain any return whatsoever.


Ponzi schemes - alive and doing very well!

Paying off earlier investors with funds received from later investors is not illegal in all parts of the world, and traps for the unwary investor abound. No more so is this true than in the fledgling capitalist economy of Russia, where the financial services industry is still in its infancy and there is a ready pool of financially uneducated individuals.

The MMM Fund was started by Sergei Mavrodi, a former mathematician. It’s stock was not traded on any exchange but instead, it made a market in its own stock with the price set by Mavrodi. MMM promoted itself to ordinary Russians with slick TV advertising and guaranteed an annual return of three thousand percent! Speculative investors were positively drooling with greed at the prospect of that level of profit. Within six months, MMM had over five million shareholders and its stock price had risen from $1 to $60.

Eventually, not having any real assets - or an infinite supply of gullible speculators - MMM was no longer able to draw sufficient numbers of individuals to fund the continued buy back of stock. It was this procedure that kept bolstering the stock price. The pyramid became unstable and MMM’s price smashed to the ground, leveling at 46 cents.

Mavrodi meanwhile, eluded prosecution on charges of tax evasion for the second time, not just because Russia has no law against ponzi schemes but because he gained a parliamentary seat. As a member of the Russian parliament, Mavrodi was able to claim immunity from prosecution. As an interesting aside, the seat became available when the previous member had been shot.

No one can deny that Mavrodi is a colorful character and perhaps it’s a sneaking admiration that lies at the root of people’s perception of him. Without a doubt those investors who got burnt gave some extraordinary justifications for maintaining their acceptance of his actions. Certainly, few investors seemed to blame him outright. ‘It was government officials who’d brought him down,’ was one prevailing view. In the new capitalist climate, Mavrodi, it seems, had become something of a folk hero. Even more puzzling was that the episode didn’t dissuade new investors from buying MMM stock after it had crashed. In terrible weather, one young woman stood in line to invest her money and explained her reason for being there: ‘I know it’s a pyramid scheme but the stock is cheap now and might go up again.’

Hope, foolhardiness, self-delusion, or simply the belief that they were just unlucky compared to those who got out before fear and panic sent the stock price plummeting to the ground. Whatever the reason these investors believed they had for placing their money in the scheme, they were all manipulated and became part of the bubble. And those who started the bubble are always looking for better ways to capitalize on investors’ propensity for greed.


Sell and store - schemers who possess may leave you in a mess!

One way schemes work better is when investors have less contact with the product or asset. There is far less responsibility involved. Furthermore, ostriches require a certain amount of care, which most investors can’t provide. What speculative investors want is for the money to come without expending any effort at all. So, where there’s a demand for a particular kind of product, someone will supply the solution.

With regular frequency investors get caught in sell and store schemes. These schemes often use the storage of metals as their investment. Metals don’t require feeding or cleaning just a place to stay!

One such scheme was brought to my attention by a client of mine, Lyndsay Marc. Seated in my office, obviously annoyed and upset, Lyndsay related how she’d found out that morning that the company with which she’d invested in titanium bars had disappeared from the face of the earth leaving a trail of debts behind.

‘And titanium is so good,’ she was saying, ‘it’s used in surgical hip replacements and even in golf clubs too. Did you know that?’

I did, as it happened. There’d been a mini-run on titanium recently and the only reason anyone could find was that golf club makers were using a bit more of the stuff. Titanium has particular qualities that make it useful, such as being light and not being prone to rust. ‘How many bars did you buy?’ I asked.

‘Fifty. And I’ve got the certificates to prove it.’ then she added quickly ‘Not as many as some of the people who introduced me to this investment.’

‘So it’s a few hundred dollars you’ve lost then?’ I said gently, hoping that things weren’t so bad after all and I’d be able to smooth things over for her a bit.

‘More like $10,000, you mean!’

I suspected what had happened but didn’t want say anything without checking my facts. ‘Let me make a call,’ I said.

Three minutes later my fears were born out. Lyndsay had put $10,000 into a metal that although useful is not as rare as the marketing of Regency Titanium had suggested. It also transpired, the directors had skipped the country but left a warehouse full of the metal. That’s one of the drawbacks for the con-men; to start their con again elsewhere, they have to buy fresh as it’s too difficult to transport the metal.

Nevertheless, titanium was worth nowhere near what Lyndsay had paid. Each bar was worth approximately $7.50. Her $10,000 was in an investment worth a total of $375.00. And that’s all she ever saw of it again.


Pump and dump - it isn’t just weightlifters who pump any old iron!

Small-scale manipulations of bubble markets happen in every conceivable asset. The profits are high for very little work and unscrupulous brokers often lie behind the scam. By working together in a ring and cold calling potential and former clients, the price of an obscure stock is bid up. But these investors end up with a lemon. When the selling stops, there is nothing supporting the price and down it falls. Hence the stock is said to be pumped to a new price level and then dumped with the investor.

This procedure has been around a long time in various forms, even before the salesman’s ‘art’ was honed for the telephone. For example, during the 1920’s, the scam was carried out with pools. Here again, there is a ring that buys a large number of shares but before selling to the public, the stock is traded between the members of the pool. With an ally on the trading floor, precise information was fed back to the pool members on tickertape price levels. Commonly known as wash sales because the illusion of activity was produced, when the price reached the level the pool wanted, the stock was sold to the public. Quietly at first and then more rapidly, in increasing block trades, the effect was to inflate the speculative bubble. By the time the bubble collapsed and unhappy investors were left with all the worthless stock, the pool had taken its profit.

More recently, inflating the speculative bubble has been taken to a new level with the promotion of chop stocks. The name refers to the spread between the price a brokerage house pays for the stock - usually a micro-capitalization, secondary market stock - and the price at which it is sold to the unwary investor. The fraud occurs when these prices bear no relationship to each other. Electronic quotes are a simple fabrication. These stocks are often obtained by the chop shops from corporate insiders or through offshore accounts for pennies. Though they may not be allowed to be legally traded, for example the stock is meant to be held for a specific length of time, the restriction is broken. Investors are duped into buying stocks at highly inflated prices and remain in darkness about what’s happened until they try to sell. At this point, the broker tries to dissuade you or may even offer you another hot stock to make up your loss - assuming that they haven’t gone out of business or the directors arrested.

According to recent findings the scale of this fraud in the US is vast. It’s estimated that these over the counter trades are a $10 billion a year enterprise. A range of middlemen and promoters are involved driving corporate networks with thousands of cold calling salesmen inflating the stock bubble. Though many of these salesmen are unwitting participants, oiling the wheels all the way to the top are kickbacks and bribes, where corporate officials, ‘consultants’, brokers, and underworld figures, all take a slice of the pie.


Don't get duped - get real

It's no easy task to avoid the lure of a fast buck. Nevertheless, as you've seen, the first task is to decide whether the bubble mania is speculative but legal - being driven by investor sentiment - or whether it is illegal - speculation being driven by scam artists who are out to make a quick killing then disappear. Over and above this, financial realism requires a good dose of self-reflection to assess whether the chance of making any profit is really likely. More often than not, over-eager investors are imagining the wealth that will accrue to them without any proper evaluation of the financial opportunity. Hope and greed alone, rather than experience and knowledge, fuels their actions.


Adapted from Profits Without Panic: Investment Psychology For Personal Wealth © Jonathan Myers 1999


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