A Stock Bubble Can Simply Result from a False Narrative

Whether it’s an investment mania or a potential stock bubble, it’s important to recognize that the information coming from the media may be little more than speculative false narratives that can have no real bearing on the market’s direction despite their wide popularity

Sir Isaac Newton, who recorded of the laws of motion and gravity and is one of the fathers of modern science, was a first-class chump as an investor, according to long-time investor lore. The story goes that Newton invested all his money in the South Sea stock bubble and went broke as a result. The truth, however, is more complicated.

A recently published academic paper by Andrew Odlyzko, professor of Mathematics at the University of Minnesota and a student of stock-market manias, shows that Newton was a successful investor, focusing on stocks and government bonds for much of his career. Toward the end of his life, however, he turned from a conservative investor into a plunger who put virtually all his capital in a single speculative stock, along with options to buy additional shares.


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A storied stock and its stock bubble

The stock was the fabled South Sea Co. It was formed in 1711 to restructure Britain’s national debt, and was granted a monopoly on British trade with South America. Newton got in early, buying his first South Sea shares in 1712. He sold after doubling his money, but the stock kept rising. He began a series of trades in the stock, generally making money, but selling too soon and missing out on much bigger gains.

In mid-1720, at age 77, you might say Newton snapped. As the price of South Sea shares rose, he began buying more and more of them. The South Sea stock bubble hit a peak a few months later, then began an epic collapse. Newton did much better than many other participants in the mania (which included three quarters of the members of the British Parliament, plus the royal family of King George I). When Newton sold the last of his South Sea shares, he still had two-thirds of his fortune intact.

Historians and other academics look at a stock bubble and investing manias as social phenomena. It seems to me that investors can learn a more practical lesson if they recognize that manias are really just financially focused false narratives that have gained a wide audience.

Understanding false narratives in your investing career

The term “false narrative” has been around at least since the 1830s, but came into common use around the time of 2018 U.S. presidential election. Each of the two main political parties accused the other of concocting and spreading an incomplete or biased story that falsely showed their candidate in a bad light.

However, it’s easy to concoct your own false narrative. If you let it guide your financial decisions, it can do as much damage to your finances as the South Sea bubble did to Newton’s. This can happen at surprisingly young ages.

Widespread false narratives—like the sure profits in South Sea shares, or the huge risk of a post Y2K depression, or the certainty that oil will hit $200 a barrel—happen rarely enough that they find a way into history. Personal false narratives happen much more often. But each one is a little different from the next, and most people would prefer not to talk about them.

Bonus Tip: Be skeptical of market indicators

You need to avoid putting too much faith in the stock market as an economic forecaster. Sometimes the market gives advance warning about coming recessions and economic bubbles. Other times, it predicts economic bubbles that never come. (This, by the way, is true of any economic forecast.)

Up to a point, national and world economies are self-correcting. They rise and fall in a series of spurts and setbacks. The setbacks always show some sign of turning into recessions. They rattle investors and upset the market. But few ever lead to serious, lasting damage.

The most experienced, successful investors feel skeptical, if not downright cynical, about economic forecasts for three reasons:

  1. Accurate economic forecasts are rare—certainly rarer than profitable stock-market recommendations. There are simply too many economic factors interacting in too many ways. That’s why nobody guesses right every time, and even the best economists can be right one year and dead wrong the next.
  2. Even when an economic forecast is right, it still may not offer helpful investing advice. That’s because the stock market anticipates economic trends much better than any economist, and moves up and down ahead of them.
  3. Fame as an economist has little to do with forecasting skill.

Bonus Tip 2: The trickiest part of investing

Deciding when to sell is the trickiest part of investing. We are programmed to run from danger, and every day the media brings new reasons to sell. But if you sell too often or too quickly, you’ll sell a lot of your best choices way too early, and you’ll never make any serious profits.

You can find numerous rules of thumb that aim to tell you when to sell. Most are based on chart-reading or technical analysis. All work at times, but none work consistently. When they fail, the profits you miss out on are likely to overwhelm any risk they help you avoid.

What is your reaction when you read reports on the latest stock bubble?

Stock bubbles come and go, but high-quality stocks are always good investments. How do stock bubbles change your choice in stocks?

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