Wednesday, July 18, 2007

Tulip bulb mania of 1630s

Thought this was a very interesting fact about the dangers of speculation. Human psychology is always the same :) Last time is trading is trading electronic bits and bytes, called 'stocks'.


Could a mere tulip bulb be worth $76,000? It is if people are willing to pay for it! It may sound preposterous, but this is exactly what happened in Holland in the 1630’s.

The seeds of this craze were planted in 1593. A man by the name of Conrad Guestner imported the first tulip bulb into Holland from Constantinople, in present day Turkey. After a few years, tulip bulbs became a status symbol and a novelty for the rich and famous. Eventually, tulip bulbs became a hot ticket item in neighboring Germany, as well. After some time, a few tulip bulbs contracted a non-harmful plant virus called mosaic. The effects of this mosaic virus were tulip petals with beautiful “flames” of color. This unique effect furthermore increased the value of the already rare and highly exclusive tulip bulb.

Initially, only the true connoisseurs bought tulip bulbs, but the rapidly rising price quickly attracted speculators looking to profit. It didn’t take long before the tulip bulbs were traded on local market exchanges, which were not unlike today’s stock exchanges. By 1634, tulip mania had feverishly spread to the Dutch middle class. Pretty soon everybody was dealing in tulip bulbs, looking to make a quick fortune. The majority of the tulip bulb buyers had no intentions of even planting these bulbs! The name of the game was to buy low and sell high, just like in any other market. The whole Dutch nation was caught in a sweeping mania, as people traded in their land, livestock, farms and life savings all to acquire 1 single tulip bulb!

In less than one month, the price of tulip bulbs went up twenty-fold! To put that into perspective, if you had invested $1,000 and came back on month later, your investment would have ballooned to $20,000! Now you can understand the mad rush to buy tulip bulbs at any cost. Tulip bulb mania affected the public psyche to an extreme. One drunk man in a bar started peeling and eating what he thought was an onion, while it was in fact it was the bar owner's tulip bulb on display. This man was jailed for many months!

All common sense and logic was thrown to the wind, and even scoffed at. This is exemplified by how many USEFUL items it cost to buy 1 single tulip bulb:

• four tons of wheat
• eight tons of rye
• one bed
• four oxen
• eight pigs
• 12 sheep
• one suit of clothes
• two casks of wine
• four tons of beer
• two tons of butter
• 1,000 pounds of cheese
• one silver drinking cup.

Mind you, these valuable items COMBINED only equaled the value of 1 tulip bulb! The modern day value of these items is over $40,000!

In 1636, tulips were trading hands on the Amsterdam stock exchange as well as on exchanges in Rotterdam, Harlem, Levytown, Horne and many other exchanges in other nearby European countries. These exchanges started to offer option contracts to speculators. These option contracts allowed tulip bulbs to be speculated upon for a fraction of the price of a real tulip bulb. This allowed people of lower means to speculate in the tulip market. Additionally, options allowed for leverage. Due to leverage, option buyers were able to control larger amounts of tulip bulbs, allowing a greater profit. In a previous example, we showed how a $1,000 dollar investment would have yielded $20,000 in one month. As if this weren’t enough, option leverage allowed this same investment of $1,000 to balloon into $100,000! Unfortunately, leverage is a double-edged sword. If the tulip bulb price moved downwards ever so slightly, the option buyer’s investment would be lost and they might even owe money! Talk about risky. But at this point, it was commonly believed that the tulip market was immune to crashing and that it would “always go up”.

After some time, the Dutch government started to develop regulation to help control the tulip craze. It was at this point that a few informed speculators started liquidating their tulips bulbs and contracts. It was these people, or the smart money, that secured large profits that were now in the form of cold hard cash. In addition, more tulip bulbs were added to the supply due to people harvesting new tulip bulbs. Suddenly tulip bulbs weren’t as quite as rare as before. The tulip market began a slight down trend, but shortly after started to plummet much faster than prices went up. Suddenly the market began a widespread panic when everyone started realizing that tulips were not worth the prices people were paying for them. In less than 6 weeks, tulip prices crashed by over 90%. Fortunes were lost. Wealthy became paupers. Bankruptcies were everywhere due to the negative side of option leverage. People that traded in farms and live savings for a tulip bulb were left holding a worthless plant seed. Many defaults occurred, where speculators couldn’t pay off their debts.

The Dutch government avoided intervening, only to advise tulip speculators and owners to form a council to attempt to stabilize prices and mend public confidence. Every one of these plans failed miserably, as tulip prices plummeted even lower than before.

Assembled deputies of Amsterdam nullified all of the contracts purchased at the height of the mania. The supreme judges of Amsterdam declared all tulip speculation to be gambling, and refused to honor these contracts. As a result, payments were not enforced by any of Holland’s courts. This further fueled the market crash.

The financial devastation that followed the tulip bulb crash lasted for decades, crippling Dutch commerce. The price of tulips at the height of the mania was $76,000; 6 weeks later they were valued at less than one dollar! The only people who prospered from the insanity were the smart money who liquidated at the top.

In market manias, the investors are acting irrationally. Excessive greed causes people to feel financially invincible and make decisions that cause financial devastation. This process occurs regardless of if the market is a commodity market or a paper market like stocks. The moral is clear; the only way to survive is to be the smart money.