Even Sir Isaac Newton lost money in a "bubble" company
Team Latte
Aug 14, 2007

Recently two of the hedge funds run by Bear Stearns collapsed and a lot of investors lost a lot of money - really serious money! In Australia as well, two funds fell victim to the meltdown in the sub-prime credit markets and then collapsed. Equity markets have fallen sharply in the past few days and so much value has been wiped out of the stock markets around the world in the past couple of weeks. Think of those who invested at the very peak!

But so what? Since the dawn of the corporate era, about three hundred years ago, a lot of investors have lost an awful lot of money in different markets and under different circumstances - all trying to speculate. The only difference is that in the last two decades the business of losing money has gotten more institutionalized. This makes the blame game so much easier. You can have the misinformed or the stupid equity analyst or the avaricious hedge fund manager as your whipping boy. Or you could blame the technology or the rocket scientist who designed the model which gave a whacky price for the asset. This way, the investors feel a lot better after he loses his money.

But just think of those days when there were no equity analysts, hedge fund managers or the Gaussian copula model (with which to price a credit derivative)!

In 1711 the British government awarded Robert Hartley's South Seas Company (SSC) a monopoly franchise to pursue overseas trade in the southern Atlantic and Pacific. There were many ups and downs and by the year 1719 the SSC realized that it had very little prospects of ever making a profit from the operations. However, instead of closing shop, the company did the unthinkable; it offered to assume the entire public debt of England and launched an aggressive campaign to sell shares. The idea was to push up the share price.

The price did start to rise, thanks to leading politicians of the day and some Dutch investors jumping in early. In January 1720 the share price was GBP 128. Within three months the price jumped to GBP 380. After the offer was accepted in April of that year the price rise became even steeper. This was a time when not only the wealthy but the entire middle class populace of Great Britain became obsessed with start up companies and buying shares to speculate. Investment in South Seas Company was no exception. If anything the hype and the investment frenzy was multiplied many times.

One very reluctant and a very savvy investor was Sir Isaac Newton, the famous physicist. We all know of him, but very few of us may know that he was also the Master of Mint at that time.

He remained skeptical of the South Seas Company and other such "bubble" companies sprouting up all over Britain. He was very hesitant to invest in such "bubble" companies. However, it was difficult for him to sit and do nothing when everyone around him was getting rich. So he finally caved in to the pressure and bought shares in South Seas in June of 1720. The price at which he bought the shares were GBP 1,020 (in a span of five months the price had gone up by almost 700%).

Then the markets crashed. The price of South Seas crashed as well and by December, 1720 the price went back down to GBP 128 (a drop of almost 700% from the peak price in just five months). A lot of fortunes were wiped out and a lot of families lost everything they had. And of course, Sir Isaac Newton lost money as well.

Newton lost GBP 20,000 (a huge sum in those days) of public funds. He could never forget this incident ever in his life. His comment was: "I can calculate the motions of the heavenly bodies, but not the madness of people."

Reference: from Daniel Friedman's excellent book Morals and Markets (Chapter 7, Financial Bubbles and Crashes)

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