The Madness of People

I can calculate the motion of heavenly bodies, but not the madness of people.

Sir Isaac Newton, maaaaaybe

Isaac Newton wasn’t just a smart dude. His singular intellect frightened people who knew him, and scientists for centuries regarded him as the greatest scientist who ever lived. It probably wasn’t even close for most people.

Newton invented a new form of math to explain the unexplainable in nature, and in case that wasn’t enough, he pretty much invented modern physics with his universal law of gravitation (Newton’s First Law) and his unification of earthly gravity with celestial motion was shockingly profound.

There was nobody better equipped to answer a question about mathematics or physics. If you wondered something about the natural world, Newton probably had your answer.

And yet, the greatest thinker for several hundred years succumbed to the same mania that captivated much of upper-class England during the early 18th century.

That’s right: Newton lost his shirt during the South Sea Bubble.

What happened?!?

We need to go back before the formation of the bubble to understand the context. In the early 18th century, England was absolutely mired in debt. An incredibly costly war with France demanded new ships to replace the ones the French had sunk, and England’s overseas colonial expansion had become a huge burden on the nation.

Meanwhile, from those very same colonies came a potential solution, so a company was formed to take advantage of some of these more lucrative opportunities. Financial innovation took center stage, and this new company would now own a considerable chunk of the government’s gargantuan debt—in exchange, the company could only ever do business with England itself.

This nifty little swap—debt in exchange for equity—was intended to ease the government's financial burden by reducing its annual payments, and by providing it with a single, manageable creditor.

So, in 1711, this new company, called the South Sea Company, was formed. It would trade with Spain in the Americas, including selling human beings (slaves) to the Spanish. It would seek to profit from selling the Spanish the manufactured goods they would need in order to survive and thrive in their colonial possessions, and it would bring back a boatload of gold, silver, and other commodities.

You could almost feel the money pool starting to fill up.

Unfortunately for the South Sea Company, the actual trade in the Americas was much less like a money pool, and much more like a solid block of metal.

Early returns were modest, raising doubts about the company's true potential. Spain wasn’t about to hand England a geopolitical gift so easily. Contrary to expectations, the Company was off to a rotten start.

Then, hope returned to the original South Sea Company investors. In 1718, King George I became the company’s “governor”, bolstering confidence in the way only the Federal Reserve can manage to do today. It didn’t really matter that George wouldn’t really do anything; the fact that the sovereign was willing put his name on the door, so to speak, was plenty.

Next, the company began offering a very generous dividend, returning cash to investors … from the capital new investor brought in.

If this sounds familiar to you, you might already be familiar with Bernie Madoff. He pulled off a similar scheme in the US in the 2000s. So did another fella by the name of Charles Ponzi, but I’ll write about him later.

From here on out, the details are unique, but the story rhymes with every major financial crisis from the last 300 years. The Ponzi hype train took over, and shares of the South Sea Company became priced so ridiculously highly, they no longer bore any relationship whatsoever to the expected return.

Instead, speculation had completely taken over. All you needed to do was to find another sucker, and as long as there was a “greater fool” than you, all you had to do was sell when you were up.

There was such a thing as a free lunch!

Borrowing to buy shares (“margin” or “trading on margin”) introduced an even easier way to blow the bubble up. More and more people borrowed to buy, pushing share prices even higher, giving the South Sea Company more money to pay out dividends, and so on.

Other speculative companies took note and copied what they could, creating an even bigger bubble in company ownership.

The only thing that could possibly go wrong would be a catastrophic loss of confidence. Wouldn’t you know it, this was very much in the cards.

By 1720, doubts about the sustainability of the Company had begun to emerge. A handful of shrewd investors decided to make a graceful exit, cashing out while they were way, way up. At first, this profit-taking didn’t really seem to matter, but the market gradually woke up to reality.

In a shockingly short amount of time, share prices plummeted, losing more than 90% of their value in just a few weeks.

In the midst of all this panic, the government attempted to shore up trust in the company by outlawing the establishment of joint-stock companies without a royal charter. I would hate to be the ones to have to tell them they were a day late and a pound short.

Word of the Company's practice of issuing new shares to pay dividends reached investors’ ears, and things got even uglier, and fast. The crash crippled the financial system, not only impacting wealthy business owners and investors, but also ordinary, everyday people.

England was in for prolonged financial instability. The wider economy suffered as it became harder and harder to borrow money, and consumers and customers were understandably shaken.

Throughout history, the greatest thinkers have been no match for financial markets. The temptation and FOMO (Fear Of Missing Out) are very real, and the smarter a person is, the more likely they are to fall into a trap of invincibility.

Smart people are not immune from the herd mentality and groupthink. The idea that you’ll be able to get out at the right time, unlike everyone else, is badly misplaced confidence. Everyone is capable of fooling themselves, especially if the promised reward is high enough.

If Isaac Newton doesn’t convince you of this, there have been countless others that I’ll write about some other time.