The One Thing Newton Could Not Calculate

Though not the first financial market debacle of its kind, the boom and bust of Britain’s South Sea Company is the financial event that gave birth to the descriptive term “bubble.” And, despite taking place in 1720, it continues to provide lessons that are instructive for present-day investors.

Before its shares experienced a meteoric rise and catastrophic fall, the South Sea Company was a bumbling shipping company. Then, in 1719 the company secured from the British Parliament a monopoly to trade with colonies in the West Indies and South America belonging to Spain. To repay the government for granting it this monopoly, company shares were issued to holders of British government debt in exchange for their debt, thus removing the obligations of Parliament from private hands. Government debt holders were amenable to this swap since the South Sea Company had a government-issued and protected monopoly that, it would seem, was certain to become very valuable.

In the first half of 1719, shares of the South Sea Company traded hands for 128 British pounds apiece. Through tremendous company-generated promotion, much of which proved later to be false, the share price began to rise. By the end of the year, one South Sea share cost more than 400 British pounds. Using their shares as collateral, large sums of money were lent to South Sea shareholders which then were used to buy more South Sea shares. This recycling of funds produced an upward spiraling of the share price that would reach its peak in March, 1720 at close to 1,000 British pounds per share.

The economic backdrop in London at the time was ripe for a financial mania. The newspaper had recently become that period’s version of this era’s internet. New industry generates much enthusiasm and late 1719 through 1720 saw an explosion in speculative initial public offerings (“IPOs”). This speculative mania, like every one which came before and since, ended in financial ruin for a large number of its participants.

The bust of 1720 ushered in an era of economic conservatism which stymied the region for decades. As we have witnessed in recent years, widespread financial losses bring calls for punishment of those executives who presided over the boom and subsequent bust. Proposed levies for the perpetrators of the South Sea mania were severe. One member of the House of Commons believed South Sea directors should be sewn into sacks – along with a snake – and drowned. (To which we ask, why harm the snake?!)

Gravity Exacts a Price

While the bubble was inflating, the general perception was that only a fool would not eagerly invest in shares, including those of the South Sea. Sir Isaac Newton was no such fool. As the inventor of calculus, pioneer in physics, expert chemist, and Master of The Royal Mint (producer of England’s currency) for 28 years, no human being prior or since was more equipped intellectually than Newton to steer clear of the irrational boom-and-bust traps of financial markets. But not even he could resist the allure of the chance to get rich quickly.

Newton was a shareholder of the South Sea Company in the years before its explosive lift-off. Having first bought shares in 1713, Newton’s investment managed to produce a small profit. Then, with the share price ascending parabolically, Newton wisely sold. At this time, says Jeremy Grantham, Newton “suffered the most painful experience that can happen in investing: he watched all of his friends getting disgustingly rich.” This proved to be the fatal blow to his immensely powerful and rational mind. Newton’s emotions took control. He purchased South Sea shares again – though now at a much higher price – using borrowed money for much of the acquisition.

Within the same year, the South Sea share price peaked and then quickly fell. Newton sold near the bottom. Succumbing to the emotions of envy and greed, he wound up losing much of his life’s savings. Whereas one could live quite nicely for an entire year on 200 British pounds, Newton’s losses may have approached 100 times that amount (or the equivalent of several million dollars today). Newton, the great thinker whose finances were felled by the siren song of financial markets, later lamented, “I can calculate the motion of the heavenly bodies, but not the madness of people.”

All the more surprising was how someone of his cognitive caliber could fall prey to such irrational behavior. The philosopher Voltaire said Newton otherwise “was never sensible to any passion [and] was not subject to the common frailties of mankind.”

Though he could never again bear to hear the name “South Sea,” the experience made Newton realize that there was no room for speculation with his life’s savings. From that time forward he took the more cautious road with his personal finances. By the time of his death seven years later, Newton was again comfortable financially.

Lessons for Investors Today

Try to remain free of emotion. Decision making can be at its worst when emotions creep into what should be a purely rational equation. Neither excitement nor despair has any place in the thought process of a successful investor. Yet it continues to consume the minds of many market participants. “I could make a fortune!” or “This is going to zero!” are two such examples that can easily hijack one’s decision making process. As Newton proved, staying rational is a difficult task for even the smartest individuals throughout history.

Purchase companies for the long-term. The stock market can be a casino for gamblers or a place where investors participate in the long-term growth of high quality businesses. Seek to own companies that have the capacity to earn consistently high returns on capital and to grow their earnings slowly but surely over time. Warren Buffett likes to acquire shares of companies as if the stock market will be closed for the next ten years. He is not interested in the buying and selling of shares but in the holding of stable, unexciting – yet profitable – companies. When it comes to investing, boring is beautiful.

Avoid the exciting. The South Sea Company was anything but boring. It was far more akin to an over-hyped dot-com stock or an Enron with what proved to be fictitious earnings. A lesson still valuable today is to avoid those types of companies and especially so if your friend or neighbor claims to be making a fortune in them. Situations like those are often on the verge of ending and getting out before the tide turns is dangerous to attempt. And if these situations sound too good to be true, it is because they usually are. Such is the way with speculations.

Peter Lynch, a top mutual fund manager during the 1970s and 1980s, once said, “If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the carpool or on the commuter train – and succumbing to the social pressure, often buys.” He also avoided companies that were overly promotional. “A flashy name in a mediocre industry attracts investors and gives them a false sense of security,” he wrote in One Up on Wall Street.[i] One simple method Lynch used was to be suspicious of companies whose name included the letter x. (Companies possessing an x in their name occur 17 times more often than the letter x appears in English words. Apparently x sells.) Lynch did not discover new ways to view the laws of motion, gravity, or various forms of mathematics. But, when it came to investing, he knew what to avoid and how to focus on the long term.

[i] Peter Lynch is one famous investor who successfully resisted the type of market temptations to which Newton fell victim. We use Lynch as an example here and not just because he was born in Newton, Massachusetts.

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