Speculative Bubbles:

"Financial Genius Before the Fall"

Behavioral Decision Making

Fall 1996

Jacob Freifeld

Wednesday, December 04, 1996


Word speculation (spek'yuh-LAY'shuhn) n.

Definition --n. 1. a. The act of speculating. b. Contemplation of a profound nature. c. A conclusion, opinion, or theory reached by speculating. 2. a. Engagement in risky business transactions on the chance of quick or considerable profit. b. An instance of speculating.

Domain Economics, Finance, Econometrics

Word investment (in-VEST'muhnt) n.

Definition --n. 1. The act of investing. 2. An amount invested. 3. Property or another possession acquired for future income or benefit. 4. Investiture. 5. Archaic. A garment; vestment. 6. An outer covering or layer. 7. A military siege.

Domain Economics, Finance, Econometrics

Almost everyone, in one way or another, makes investments via the financial markets. Whether deciding what stocks to buy themselves, relying on the decisions of an investment manager when purchasing mutual funds, or relying on a company pension plan, most people are financially dependent on decisions made about their investments.

Others, for fun or profit, choose to speculate in the marketplace. This involves making short term, risky bets on the value of one security or another. Investors and speculators have different goals; investors look for long term gains at relatively little risk, and speculators go after large, quick profits while taking large risks.

Investing and speculation are all about decision making. In particular, they are about decision making under uncertainty, and under the alternating emotional pressures of greed and fear. Under most circumstances, the market is dominated by rational investors who are willing to pay reasonable prices for stocks based upon reasonable, feasible expectations for a given company's future. However, periodically throughout the history of free markets, there have been recurring "speculative bubbles" in which the market for a given stock, all stocks, or other assets such as real estate, art and even tulip bulbs is overcome by euphoria and rushes upward, only to collapse a short time later, usually over a time period spanning less than three years. What causes these bubbles? Why do investors suddenly become speculators?

Experiments in virtual trading among humans in a controlled environment also show evidence of speculative bubbles, even when the money is fictional, and the "true" values of securities are given to the participants at the beginning of the experiment. In this case, participants have nothing material to gain from such speculation, and by some arguments should behave in a purely rational manner and buy and sell at or near the given "true" values. Yet experimentally this does not happen, raising the hypothesis that for some reason, an attribute of markets is that at certain points they reach levels that are clearly above the true value of the underlying goods. Why does this happen? This paper will attempt to get into the decision making dynamics of markets that are crowded with investors-turned-speculators who are eager to profit.

The Theory

Throughout history, speculative bubbles have had some common features. There are certain financial preconditions, which invariably include leverage coupled with some other financial "(re)discovery" such as the power of the joint-stock company, the option, or risky debt (junk bonds). In some cases this financial innovation is replaced by changes in government policy that either favor easy credit or lower taxation, stimulating rapid business growth. Whatever the case may be, a financial atmosphere of tremendous supply combined with demand for some desirable asset, be it stocks, real estate, or even rare tulips, gives birth to the speculative bubble.


There are two types of speculators who participate in the growth of the bubble. The first is the type of person that believes that for some reason, the price of this object of speculation will move tremendously higher, and remain there indefinitely. While this type of expectation clearly adds to the bubble, this alone will not cause the market to rise tremendously. For example, consider a theoretical market consisting of 10 investors and speculators, and one stock. If the stock is currently at $100, and one of the speculators suddenly realizes for some reason that the stock is worth $1000, they will commit all of their capital, driving the price of the stock temporarily higher until they have purchased all that their credit or margin will allow, after which the price will return to $100, or at least cease to climb.

However, the situation changes when the second type of speculator enters the picture. This type of person subscribes to the "greater fool theory" which says that an asset should be purchased as long as there exists at least one "greater fool" to whom that same asset can be sold at a higher price. This theory is also known as the "Castle-in-the-air" method of valuation. This strategy is what throws the market out of balance and fuels the second half of the bubble. These individuals will continue to purchase regardless of market levels, considering only the willingness of other individuals in the market to pay higher prices. At this point the bubble inflates itself, because a growing portion of the market is self-referencing, making decisions while looking inward.

Thus the core phenomenon of the speculative bubble is one in which euphoric levels of valuation are validated by the market, and intelligence is measured only by profits, not reasoning and judgment. This is similar to the "hot hand" maxim in basketball which says that players will predict with great confidence their ability to score again after scoring, despite statistical evidence to the contrary. In much the same way a speculator sitting on an enormous unrealized and increasing profit becomes even more confident in his/her own insight into the tremendous future profit opportunities of the bubble. Although this form of irrational representative thinking cannot be shown to be incorrect as in the "hot hand" case, it is intuitively not necessarily true that there is a direct correlation between intelligence and profits in the financial markets. The phrase "financial genius before the fall" refers to this overconfidence by both the speculator and financial innovator at the peak of the speculative bubble. Near the point at which both classes of people are hailed as brilliant and at which, according to economist Irving Fisher of Yale University "stock prices have reached what looks like a permanently high plateau," the bubble is at the bursting point.

The speculative bubble as a phenomenon of free markets would not continue to resurface time and again were it not for the fact that the financial memory of a given society is very short term. Veterans who have experienced previous bubbles and warn of disaster are quickly ignored by fresh, young generations, eager to realize tremendous wealth through speculation. Even after the debacle of 1929, which led to the worst post-speculation economic depression ever, speculation was back in style a mere forty years later in the form of the "New Era" growth stock craze and the "tronics boom," in which any company with "electronics" or "silicon" in its name was worth three times a comparable, but not so cleverly named company.


Who sells during a speculative bubble? During such periods of euphoria it may seem bizarre that anyone would be a seller in the marketplace. However, common sense tells us that without a seller for every buyer, there are no transactions (until the buyers offer to pay a high enough price that there are people willing to sell again). There are three types of sellers during a bubble. The first is simply the speculator unloading shares (or whatever the speculative asset may be) to cash out or to free up money to plunge into other classes of bubble stocks, tulips, or whatever the case may be. The second is selling as part of their normal business of dealing or making a market. Although securities dealers are most visible, there are professional real estate and art dealers, and at one time there were professional tulip dealers. These professionals (if that is the right word) buy and sell frequently and for the short term, keeping the market liquid and earning good, low risk money at the same time. The third type of seller is the "bear," or speculator who is betting against the bubble, borrowing shares and selling them in anticipation of a price decline, with a commitment to purchase and return them at a later date.

Examples of Speculative Bubbles

The Tulip Bubble

There is some record of speculative bubbles dating as far back as the 1300s, but the first that stands out from history took place in Holland from approximately 1620 to 1637. This speculative bubble involved rare, collectible tulips. The tulip, native to the Mediterranean, was first imported to Holland well before 1600. Beautiful tulips gradually became collector's items for wealthy Dutch people. As time progressed, rarer and more valuable classes of tulips emerged. Tulips mutated by botanists and others infected by a virus called "mosaic" (which did not kill the tulip, but instead caused its petals to develop contrasting "flame" patterns) began to sell for incredible prices. Entire homes, horses and carriages were traded for tulip bulbs in some cases.

Further enabling the bubble was the innovative climate of Dutch finance. While futures contracts had been in use for several centuries by this time, Dutch speculators invented a new financial instrument similar to what is known today as the option. The low cost and tremendous leverage of this security broadened the speculative frenzy and allowed all members of Dutch society, including farmers, chimney sweeps and maid-servants to give up their jobs and speculate in tulip bulbs. Land and other assets were pledged for credit with which to purchase tulips, bringing leverage into the picture.

In 1637 the bubble stretched and burst. Credit had been exhausted; bulb dealers were unable to find buyers for their more expensive bulbs, sparking a selling panic. The plunge in tulip bulb prices left many who had purchased on credit bankrupt. Earlier contracts to purchase (such as futures and options) were defaulted upon, and soon a nationwide depression followed. In the end, rare tulips sold for almost nothing, down over 99% from their peak.

The South Sea Company

In England, from 1711 to 1720, the short life of the South Sea Company is almost purely based upon speculation. The financial innovation of the day was the joint-stock company, which we know today as the publicly-traded corporation. Against the backdrop of other absurd joint stock companies (soon to be known as "bubble companies") such as one to produce a machine gun that fired both round and square bullets, Robert Harley, Earl of Oxford founded the South Sea Company. The company was chartered by the English government in return for assuming the country's massive war debts, for which they were paid 6% interest. In addition, the government granted the South Sea Company a permanent monopoly over trade to North and South America. Although the company was unable to ever profit in any way from this franchise (because Spain controlled most of the Americas), the potential that this "monopoly" presented was irresistible. The few English who had profited in the recent wars drove the price of shares to £128 in January of 1720, and soon other British aristocrats succumbed to greed and drove the price higher, peaking at £1000 in July.

Throughout 1720 other "bubble companies" had formed, with ridiculous but attractive business plans such as to "transmute quicksilver into malleable fine metal" and the most infamous, to "carry on an undertaking of great advantage, but nobody to know what it is," which resulted in the one day sale of £2000 worth of shares and the promoter leaving the country that same day. Soon after, the government passed the Bubble Act, outlawing all such scams, except for the South Sea Company. This broke the fever, and the shares in the South Sea Company collapsed, reaching 124 by the end of 1720. Incredibly, the bulk of this speculative bubble happened inside of one year.

The Florida Real Estate Craze

Beginning with Florida real estate, the 1920's saw the greatest period of speculation in American history. Sparked by the favorable climate, farmers who wished to enjoy warm winters while their land lay fallow purchased plots of land in Florida. They were soon followed by successful bankers from New York, eager to vacation and flaunt their wealth at the same time. Then, as is true today, real estate could be purchased on mortgage for only about ten percent down, which provided the financial leverage for the boom. Mania rapidly built, with acres of Florida swampland going for up to a thousand dollars (a lot of money at the time) and dirt being trucked in to make swamps into land to meet the demand of speculators. At the peak, one third of the population of Miami consisted of real estate agents which in hindsight should have been a warning of impending disaster. Among wealthy Americans, a contest of extravagance took place, with everyone trying to own the most palatial estate around.

The Florida real estate bubble was burst prematurely by a sudden hurricane (hardly unknown to the region) which destroyed many homes and caused tremendous property damage. Soon prices collapsed, and the usual bankruptcies and defaults followed not far behind. Florida was quickly forgotten as speculation went national in the stock market boom of 1926-1929.

U.S. Stocks


In the early 1920s the business climate could not have been better. According to the president "the business of America [was] business." The American businessman reached a level of social status usually reserved for accomplished professors or diplomats. Corporate profits, Pro-business government policy and margin rates allowing stock to be purchased for only 10% down pumped the market for U.S. stocks to euphoric heights from 1926 through September of 1929. In what seems to be an occasional feature of speculative bubbles (see the Presstek example below), near the peak there was some debate among prominent economists and bankers about whether the market was headed for boom or bust. Those who predicted a crash were criticized and scorned into silence by rabid speculators caught up in what seemed like a new plateau of stock valuation.

As the limits of demand and capital were tested in September 1929, the market drifted slightly lower, and then the selling built into a deluge. During two October days, more than $9 billion of the market value of American business was erased in a panic that left prices 25% lower. Far more devastating to the country and the entire world was the depression that followed. Stock prices bottomed 90% below their 1929 highs in the aftermath of what is probably the most far-reaching and widely felt speculative bubble in economic history (the tulip mania may have been more worse, but it was focused in Holland).


After 1960 the disaster of 1929-1934 seemed to be fading from the collective social memory, and once again market players began to compete with each other in search of maximum returns. The mutual fund was all-powerful, as it is today. "Go Go" fund managers outgunned each other with successively more aggressive investment strategies. Technology (or what sounded like it) was the favorite impulse purchase of the day. By 1961 it became clear that concepts or even just words relating to "electronics" or "silicon" multiplied the market value of a company.

The name was the game. There were a host of "trons" such as Astron, Dutron, Vulcatron, and Transitron, and a number of "onics" such as Circuitronics, Supronics, Videotronics, and several Electrosonics companies. Leaving nothing to chance, one group put together the winning combination Powertron Ultrasonics. The prices commanded in the market by these companies was unbelievable.

Hardly a year later, in 1962, the bubble burst. The market declined slowly throughout the early part of the year, and by the end of May it cracked downward. Not surprisingly, the "tronics" stocks and other growth stocks took the lion's share of the beating. Boonton Electronics, for example, declined to $1.62 from it's 1961 high of $24.5.


For the stock market, the years 1984-1987 were strikingly similar to 1926-1929, yet few noticed until after the fact, and then history did not repeat itself, throwing even more people for a loop. The boom was built on leverage and loose government economic policy, just the way it was in the '20s. There were some new "innovations," which in some ways were hardly innovative. Junk bonds, the debt of less creditworthy companies, were found to be exceedingly useful in purchasing companies from their shareholders. In speculative, self-referencing style, this strategy was wise as long as the stock market continued to rise and the companies could be taken public again later for more money. Other financial innovations included program trading and stock index futures, both of which increased the speed and leverage with which investing and speculation could be accomplished.

The fever peaked in October of 1987 and the stock market fell 20% in a single day. Suddenly, fears of 1929 reawakened in the American population, and many expected a heavy recessionary hangover. Incredibly, partly due to the fact that the government stepped in 5 years earlier than they did following the crash of 1929 (the Federal Reserve announced that they would guarantee the credit of market makers the day after the 1987 stock market crash), the recession never came. As fortunate as this may seem, it sets the stage for the next two speculative bubbles, and it could mean that the hangover is still to come.

Presstek and Centennial Technologies

Continuing in chronological order, a recent outgrowth of the 1994 to 1996 boom in technology stocks was the bubble in the shares of Presstek, a developer and marketer of digital imaging technology. Not a terribly hot industry, especially when compared to the booming internet hardware and software business and when considering Xerox and Kodak, the competitors that Presstek faces. However, under the promotion of Carlton Lutz, editor of the Cabot Market Letter, a newsletter which follows rising growth stocks, the price of Presstek stock soared from $40 to nearly $200 in less than a year. In a miniature repeat of "tulip mania," many investors convinced themselves that this was the "stock of the decade" and that it could never turn back. The most interesting wrinkle in this example is that unlike the great speculative bubbles of the past, the arguments, differences of opinion and changing expectations for Presstek are recorded in various internet discussions, in which the reader can match the discussion to the dates on the graph of the stock's price history, hearing the mania directly from the speculators while the stock is on the way up and listening to them groan after the stock collapsed 60% in a matter of two weeks. The discussion is publicly viewable on the World Wide Web at http://www.exchange2000.com/~wsapi/investor/subject-2838.

Presstek shares from December 5, 1994 to December 4, 1996

Although one can almost close the books on the Presstek bubble, Carlton Lutz and the Cabot Market Letter have not been idle. It seems that Centennial Technologies is the next "stock of the decade." The company makes plug-in cards for laptops and PCs, a business that is just as much a commodity business as Presstek's. But hope and greed spring eternal. It is still early on, and the stock is roaring higher day by day. Caveat Emptor.

Centennial Technologies shares from December 5, 1994 to December 4, 1996


Currently the U.S. stock markets are in the late stages of what looks like a speculative bubble. The bubble is as difficult to recognize before it's over as it is easy to spot in hindsight. However, there are some telltale signs that the market for stocks has gone a bit too far. The market averages returned 33% in 1995, and 22% year-to-date in 1996, both numbers far above the 100-year average of 10% per annum. With the most recent frightening recession and associated market decline having ended more than 15 years ago, it is little wonder that many young, inexperienced investors are shoveling their savings into high-performance mutual funds. Once the reality of investment losses slips into history, it quickly passes from the collective financial memory. The current climate for American business is exceptionally comfortable, with inflation remaining dormant and corporate profits growing rapidly. The necessary "financial innovation" of the current boom is the belief that the government can keep this sunny business climate around forever, and that the mutual fund is a sacred investment vehicle. Should any of the inflation or growth numbers (or even public opinion) change unexpectedly, the 1994 to 1997 bubble in American stocks could be the next example written into the history books.

The Theory vs. The Examples

Throughout each of the above examples there are common features. Leverage and other financial innovations or "permanent advances" played a part in every speculative bubble. In every bubble the excess capital, optimism, hope and greed is blown off in a speculative frenzy, only to return again after years of economic contraction or tight credit.

At the core of the speculative phenomenon is the individual, swept up in the euphoria of the crowd, attributing intelligence to those who make profits or becoming overconfident in their own judgment when they begin to profit from speculation.


What conclusions can be drawn from the these theories and examples? Clearly, the speculative bubble is as much an error of decision making and judgment as confusion of the inverse, hindsight bias, or the gambler's fallacy. In fact, hindsight, probability and gambling are integral parts of the speculative bubble. What makes the bubble more complicated, however, is the fact that it is a social phenomenon. As pointed out in the earlier discussion of the different speculative heuristics (or types of speculators), one person who believes an asset is tremendously undervalued will not cause a bubble, but rather a temporary up tick in prices. It is the group, the crowd that gives birth to a speculative bubble. This makes the task of improving judgment more difficult. It requires the individual to break away from the crowd and think logically about history, value and probability. Hopefully, examples from history such as those above will help people to begin to do just that, lessening the magnitude of speculative bubbles in the future. This raises the question of whether cycles of speculative bubbles are healthy or harmful, which is beyond the scope of this discussion.

Appendix: Quotes/Thoughts

Caveat Emptor. In the case of speculative bubbles, sellers should also beware.

"What is a cynic? A man who knows the price of everything, and the value of nothing."

-Oscar Wilde, Lady Windermere's Fan

"What is a stockbroker? A man who knows the price of everything, and the value of nothing."

-Heard on The Street

"October. This is one of the pecularly [sic] dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February." -Mark Twain, Pudd'nhead Wilson

"Anyone taken as an individual is tolerably sensible and reasonable-as a member of a crowd, he at once becomes a blockhead."

-Friedrich Von Schiller, as quoted by Bernard Baruch

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation."

-John Maynard Keynes, The General Theory of Employment Interest and Money

Bibliography/Suggested Further Reading

1. A Short History of Financial Euphoria, John Kenneth Galbraith, Whittle Books, 1993

2. Scientific American, unknown article (personal recount of an article on simulated, virtual markets)

3. A Random Walk Down Wall Street, Burton G. Malkiel, W. W. Norton & Co., 1985

4. The Great American Land Bubble, A. M. Sakolski, Harper & Brothers, 1932

5. The Lore and Legends of Wall Street, Robert M. Sharp, Dow Jones-Irwin, 1989

6. Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay, LL.D., Richard Bentley, Publisher, 1841 (from a 1980 reprint)

7. Rational Choice in an Uncertain World, Robyn M. Dawes, Harcourt Brace College Publishers, 1988

(Archivist's note: Preserved from Jacob Freifeld's work at http://www.clarity.net/~jake/bubble.htm.)