Tulip Mania is arguably the finest example in history of impact that behavioural finance can have on fundamental values.
Introduction
In the 1630s, the first, and arguably the most remarkable example of a speculative bubble took place in present-day Holland. Part of what makes this speculative episode so extraordinary, comes down to the asset that was driving the speculation – tulips. Tulipmania, the name of this particular speculative event, was a brief period in Dutch history where the price of tulip bulbs reached preposterous highs, before crashing back down to reality.
Timeline of Events
Foundations of a Speculative Bubble
After Tulips made their way to Europe, and then Amsterdam, through trade with the Ottoman Empire, attention was soon fixated on the possession and display of the more unusual blooms of the tulip. This increasing desire for possessing and appreciating the most exceptional of the flowers, quickly become trivial as far greater interest was placed on benefiting from the rapid increase in the price of the bulbs. By the 1630s, this was the primary reason that tulip bulbs were traded, as their price seemingly increased without limit.
Peak Mania
The mania soon engulfed all of Holland, as the population become more worried about being left behind in the race to make money from tulip bulbs as the notion of losing money from buying tulip bulbs at such extravagant prices seemed such a remote possibility – if at all possible. In his book “A Short History of Financial Euphoria”, John Kenneth Galbraith states that by 1636 “a bulb of no previously apparent worth might be exchanged for ‘a new carriage, two grey horses, and a complete harness’”. I have no idea, nor am I inclined to work out, what this is equivalent to in today’s money, but it does seem excessive for one tulip bulb!
Initially, as with all speculative bubbles, confidence was high as everyone involved made money
The speculation became increasingly frantic, as the demand for rare tulips increased so drastically. Thus, in 1636, regular markets were established on the Stock Exchange of Amsterdam for trading tulip bulbs. Initially, as with all speculative bubbles, confidence was high as everyone involved made money: it doesn’t take much investment skill to earn impressive returns when the price of the asset increases day-by-day; instead, it takes a willingness to gamble on the continued upward price movement. People from all backgrounds converted their property and other assets into cash to invest in tulips. Moreover, foreigners became intrigued by the apparent ease with which so many Dutch were becoming rich, and began to pour money into Holland.
Collapse
In 1637, came the end of one of the most intriguing speculative bubbles in history. Some researchers have proposed theories as to what caused the collapse in tulip prices: however, I feel this is of little importance; if an asset is priced at a level so far removed from its intrinsic value, it cannot and will not go on forever. In fact, often the so-called reason(s) for the “popping” of speculative bubbles is more likely an anchor that enables speculators to coordinate their activities by realising that the speculation has gone on long enough and it’s time to get out before losses ensue. Accordingly, the “rational” and the more-timid speculators began to sell; other participants noticed the diminishing demand; and, soon, the rush to buy tulips became a panic to sell, as prices seemed to fall off a cliff.
Aftermath
The result of this spectacular collapse led those individuals that had entered contracts to buy tulips at vastly inflated prices defaulting en masse, as they quickly realised the true value of a tulip. Those that had taken on debt or sold their assets to fund speculation were now left with huge losses or worthless tulips; leading to an impoverishment of Dutch economic life. However, one long-lasting result, that we can still see today, was the cultivation of the tulip in Holland; perhaps the only reminder of financial speculation in the natural world.
What Caused Tulipmania?
Self-Fulfilling Prophecy
As with most speculative bubbles, the fuel driving still higher prices is the increase in the price level itself. That is, every time the price of tulips increased, it persuaded more and more people to participate in the mania. Moreover, it justified the mania to those already participating; encouraging still further speculation and the reinvestment of any proceeds from trading tulips.
Emergence of an Innovative Product
Like many periods of intense speculation, the kindling that initiates the speculation can possess some quality that offers a fundamental and objective increase in wealth; the clearest example of this is the Dot Com bubble and the promise of internet technology in the late-1990s. It captures the imagination of the financial participants and the public at large, until other factors drive the price of the asset well-beyond any potential wealth benefits that it offered.
In the case of Tulipmania, public opinion settled on something new in the field of commerce and the apparent uniqueness of tulips in comparison to flowers that were present in Western Europe at that time. Of course, the tulip is, without doubt, one of the most unusual instruments to start a speculative bubble. However, as in all speculative episodes, the characteristics of the underlying asset quickly becomes irrelevant as more and more people start to buy it for speculative purposes along, and the speculation begins to build on itself provided by its own momentum.
Irrationality in Financial Markets?
Some would argue that Tulipmania, and successive speculative episodes, is evidence of the irrationality of economic agents; this goes against the commonly held assumption of homo economicus, or the notion that individuals are fully rational. I would disagree, however.
To explain why, let’s contemplate how homo economicus would behave during Tulipmania, assuming perfectly rational economic agents did exist. For instance, suppose there was someone that know the objective, fundamental price of a tulip bulb. Moreover, assume that they could perfectly forecast (or see into the future) the future movements in the price of tulips. Would it not be irrational to not participate in the “irrational” speculation if they know that the price of tulips would be higher tomorrow than they are today, even if this meant paying a price that was far above intrinsic value? Accordingly, the promise of continued price increases can actually justify the seemingly bizarre action of paying well-above intrinsic value for an asset.
Accordingly, although the outcome and behaviour of the market as a whole appears irrational, from the perspective of individual market participants, contributing to the continued increase in speculation may, in fact, be perfectly rational.
Concluding Thoughts
Overall, I believe Tulipmania is the greatest example of human irrationality playing a decisive role in the performance of an asset's price and financial markets. In my view, it validates my belief that security prices can never be forecasted by fundamental values or advanced mathematical models, as it is impossible to incorporate societal beliefs and the opinions of individuals into any model.
Moreover, the idea that governments have a way to regulate speculation of this nature seem unfeasible, and I strongly believe that speculative bubbles will play a role in financial markets as long as humans are managing money.
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