In all speculative episodes there is always an element of pride in discovering what is seemingly new and greatly rewarding in the way of financial instrument or investment opportunity.

—John Kenneth Galbraith

Frogs have almost 360-degree vision because their necks can’t move much. When a frog’s vision works in concert with their appetite it can produce some strange reactions. Put a dead fly on a string and dangle it in front of a hungry frog and it won’t eat it. The frog is almost entirely unaware the fly exists. But put a live fly in the same room as a hungry frog and the frog will do everything in its power to pursue its prey. You see a frog’s eyesight works in such a way that they can only see certain objects when they’re moving. If it’s not moving, it doesn’t even register to the frog.^[1]

Financial markets work much in the same way when it comes to triggering the human brain to pay attention. The slow, methodical, long-term movements in the stock market aren’t exciting so it basically registers as a nonevent. It’s much easier to notice the high-flying stock or fad investment du jour that moves quickly in the short term. Those quick moves are what cause investors to overreact and make mistakes causing people to make short-term decisions with long-term capital at stake. The biggest difference between us and the frogs is they have more discipline to wait it out when the dead fly is dangling in front of their face than we do. Stability almost acts as its own form of instability in the markets because the human brain craves another hit of dopamine once it experiences a change in the status quo.

This idea that stability can lead to instability was first developed by economist Hyman Minsky. Minsky published The Financial Instability Hypothesis in the early 1990s, claiming, “Over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.”^[2]

In non-economist speak, this means a stable financial system eventually tempts investors to borrow money to buy more expensive assets, which leads to the inevitable downturns when investors go overboard. Minsky was basically explaining the idea that markets have cycles that go from periods of stability to periods of instability and back again. But he was also laying out the case for how bubbles occur. People get bored. They take risks they shouldn’t take when markets get expensive by borrowing too much money to juice returns. And eventually the music stops and the dance floor empties. Success by an individual can lead to overconfidence. Success by others can lead to envy and regret. Mix overconfidence with envy and regret and you get extreme risk-taking by individuals that collectively become a herd that overwhelms rational thought. This is the Minsky moment.

Robert Shiller defined the idea of a herd mentality in his book Irrational Exuberance, which was released at the tail end of the dot-com bubble:

I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.^[3]

Financial writer and investor William Bernstein describes four conditions that are necessary for a bubble, in his book The Four Pillars of Investing:

1. A major technological revolution or shift in financial practice.
2. Liquidity – i.e., easy credit.
3. Amnesia for the last bubble. This usually takes a generation.
4. Abandonment of time-honored methods of security valuation, usually caused by the takeover of the market by inexperienced investors.^[4]

There’s another element that can supercharge a bubble – fraud. Authoritative figures making faulty promises, hiding relevant information, or leaking rumors can add fuel to the fire. The man spraying gasoline all over England during the early part of the eighteenth century was John Blunt, helping create what might be the biggest bubble of all time.

The South Sea Company

Britain and France were at war with one another and other parts of the world for centuries by the time they went to battle on the economic front in the early 1700s. The British government saw what John Law was creating in France with the Mississippi Company to handle the country’s war debts. The Brits saw French citizens getting rich overnight by owning shares in a company that was taking on those debts. A combination of jealousy and anxiety caused England to follow Law’s lead by using a publicly traded company that could shoulder the debt burden of the country.

England was almost always placing itself in a superior position to other European countries, so government officials and citizens alike felt they deserved the same treatment France was getting on their debt load. Plenty of people assumed Law’s monetary plan would fail (see the last chapter: it did) but the Brits assumed it could never happen to them. In fact, Parliament signed off on the South Sea scheme at the height of John Law’s Mississippi bubble. It was a race to the finish to see which country could act more delirious.^[5]

The South Sea Company used the Mississippi Company’s playbook in that it was an exploration business that issued shares to the public in exchange for the government’s debt and annuities owned by investors. In exchange for taking on the government’s debts, the company was granted a monopoly on trade routes in the South Seas. Everyone heard rumors of endless amounts of gold and silver in places like Peru and Mexico. Investors actually believed these resources were inexhaustible and that all it would take was a handful of ships to bring home untold riches. Let’s just say this take didn’t age well.

The company started out relatively small, taking over £10 million in debt from the government. But once the government and public collectively grew jealous of John Law’s scheme in France, it was time to take it to another level. In 1719, the South Sea Company offered its stock to the public in exchange for Britain’s remaining debt load. When the South Sea Company led the first ever secondary stock offering in history, it was hoping to raise £2 million. It raised half of that amount by midmorning. People were pawning their possessions, and farmers were selling livestock to raise cash to buy shares. The offering was oversubscribed.^[6]

Company management hoped to increase speculative interest in the stock price to offer less and less of it in exchange for government debt, because debt holders could sell out for an immediate profit. Then the management team could keep the extra stock they helped create. And that’s basically what happened. The share price went from 129 to 360 in no time. After the first conversion it went as high as 890.^[7] The market cap of the company reached £12 million after becoming a public corporation, yet it still hadn’t made a profit. Not only that, it had still not made a single cent on direct trade with South America, which was the entire business plan in the first place.^[8]

In the span of around eight months the entire debt structure of the country had been transformed, euphoria gripped the populace, riches were made and subsequently lost, and one man was blamed more than any other – John Blunt.

Type II Charlatan John Blunt

In the last chapter we looked at the difference between Type I and Type II charlatans. Type I charlatans, such as John Law, are the visionaries who are more or less sincere but wind up ruining their investors anyways. They are intellectual frauds because they fail to take into account real-world dynamics or consider how their ideas could go horribly wrong. Type II charlatans are the true fraudsters who blatantly set out to take advantage of others for their own personal gain.

John Blunt was the personification of a Type II charlatan. The man had one aim in life – to become fabulously wealthy by any means necessary. And not only did he want to become rich, he wanted to become rich as fast as humanly possible. Unlike Law, Blunt was no intellectual. But he made up for it through a combination of self-confidence and charisma. Blunt saw an opportunity to use the government, the public, and the South Sea Company to his advantage to both erase government debt and enrich himself in the process.

Blunt was a founding director in the company and described by one account as “burly and overbearing, glib, ingenious, and determined to get on.”^[9] But Blunt also had an innate ability to get the upper echelon of society on board with his schemes through his sales ability. First he convinced the Prince of Wales to become part of the venture in 1715. Later he talked King George I into becoming a larger shareholder in the company. Even those who are already wealthy and in positions of power can be seduced by get-rich-quick schemes.^[10]

As a founding director of the South Sea Company, Blunt had every intention of using its unique corporate structure to personally profit in any way he could. Here’s the rap sheet on how Blunt manipulated this situation to his advantage:

• He purchased options on the dividends paid out by the company, dividends he himself planned on raising in short order.
• He secretly increased the number of shares going to himself and his friends.
• He bribed the courts and invested heavily in shares on behalf of friends and family members of Parliament.
• He spread false rumors as far and wide as humanly possible to pump up the stock price.
• He bribed the Secretary of Treasury, Charles Stanhope, with share options (Stanhope later sold his shares during the bubble for enormous profits).
• He followed John Law’s lead by pushing investors into borrowed funds to boost the share price. In fact, the South Sea Company itself lent money to investors to buy shares. Blunt simply wanted to flood the market to prop up the share price.

As with the Mississippi experiment, the South Sea debt-for-equity exchange made little sense as a legitimate financial trade. Yet the government loved wiping its books clean of their overbearing debt load, and the people buying the stock loved seeing their net worth increase in a short period of time. Blunt’s plan was simultaneously attractive and deceptive, a perfect mix for duping people out of their money. As share prices rose so too did investor profits, but the company still didn’t make any money. All he was doing was pulling nonexistent profits forward. The South Sea Company had no business plan and no market for its goods.^[11]

Maybe the most absurd aspect of the arrangement was Blunt never bothered to inform investors what the conversion terms were for the national debt nor did investors bother to ask. There was no set exchange rate for converting debt into a company share price. The higher the price went, the less the company would have to hand out in shares, leaving more for Blunt and the other directors to do as they pleased with the leftovers. The goal was to push the price up by any means necessary. The company spent millions on bribes, making Blunt feel untouchable, which is a common symptom among those caught up in a financial mania driven by fraud. And for a time he was, considering he was knighted for his efforts. South Sea shares were the topic of conversation among the upper class. At one point the company was valued at 10 times the size of the debt it held because Blunt offered such generous terms to entice people to trade in or buy shares. But the ships had still not taken a single voyage to the South Seas.^[12]

Whereas John Law’s financial experiment had tried (and failed) to solve that country’s debt problem using a paper currency, Blunt’s scheme truly had no grounding in reality. There was no plan B other than jacking up the share price as high as humanly possible. As the South Sea Company share price began to pick up steam, Blunt told his fellow directors, “The more confusion the better; People must not know what they do, which will make them the more eager to come into our measures; the execution of the Scheme is our business; the Eyes of all Europe are upon us.” And the higher the price of shares, the harder it became to keep the momentum going because eventually you run out of new suckers to invest. When the price of the stock finally began its descent, the majority of investors actually owed more money than their shares were worth because they purchased so much of the investment using borrowed funds.^[13]

Blunt’s plan for world domination sounded like something straight out of Dr. Evil’s playbook in Austin Powers. According to Charles Mackay, Blunt said, “that if the plan succeeded, the directors would become masters of the government, form a new and absolute aristocracy in the kingdom, and control the resolutions of the legislature. If it failed, which he was convinced it would, the result would bring general discontent and ruin upon the country.” Dr. Evil simply wanted to blow up the planet with a “laser.” At least he didn’t try to get people’s hopes up first.^[14]

The Bubble Act

The year 1720 may have ushered in the word “bubble” to the financial lexicon. It was known to some people as the “bubble year.” After the success of the South Sea Company in raising funds from investors, joint-stock companies sprang up like weeds. These companies were even called bubbles at the time, which falls under the too-good-to-be-true category of this story. The length of time these companies lasted would make some of the dot-com flameouts in the late-1990s blush. More than 100 new corporations were formed out of nowhere, cashing in on the overwhelming greed, while most lasted no more than a week or two. One company marketed a hydrostatical air pump which would “draw all manner of wind and vapours out of human brains.”

The most absurd of these business plans was for a company described as “carrying on an undertaking of great advantage, but nobody to know what it is.” For his troubles in this mysterious endeavor, the inventor of said business plan asked for a mere half million pounds. So great was the demand for new public companies, when he set up an office, crowds lined up out the door to the office, which had been set up that very same day. After one thousand shares were sold, the man closed up shop, left the country and was never heard from again. Talk about a get-rich-quick scheme!^[15]

All of this competition for the greed which had infected the populace meant fewer people paying attention to South Sea shares, so the price began to fall. With the help of his paid-for friends in Parliament, Blunt was able to push through legislation called the Bubble Act, which made it harder to start a new company without prior government approval. This gave the South Sea Company a monopoly on speculation, but the victory was short lived. Once a selling stampede begins there’s not much the government can do to stem the tide. After hitting a price of £1,000 in August, shares quickly fell to 150 by September. The company never came close to making a profit and ended up a money-losing venture.^[16]

The company’s collapse reverberated through Great Britain. Thousands of people went bankrupt. Banks were also out of luck because they couldn’t collect the money owed to them by investors because the collateral used for margin accounts was worthless shares in South Sea. No one wanted to blame the speculators themselves. Everyone wanted a scapegoat. Charles Mackay explained:

Nobody seemed to imagine that the nation itself was as culpable as the South Sea Company. Nobody blamed the credulity and avarice of the people – the degrading lust of gain…or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned.^[17]

Charlatans and hucksters like John Blunt are never going away. There will always be fraudsters that strike the match but it’s the crowd psychology that provides the accelerant. No one bothered to perform even the faintest research on the prospects of the company itself. Not a single ship had set sail anywhere close to the South Seas! Blunt was forced to retire in Bath with just £5,000 to his name and all of his other assets confiscated.

The Echo Bubble and Dunbar’s Number

For hundreds of thousands of years, our ancestors functioned mainly in small tribes. Life was hard. Each individual had their own job, and in large part everyone was simply trying to survive. One of the reasons these tribes tended to be small is because there is a relationship between the size of our social groups and the size of our brains. As our brains evolved over tens of thousands of years Homo sapiens began to form larger groups through word of mouth, and to some degree, gossip. The upper band of this number is around 150 people according to sociology research.

Dunbar’s number is named after the anthropologist Robin Dunbar who theorized that the natural size of a group is about 150 individuals. Dunbar posited that judging by the size of the human brain, this is the number of people the average person can have in their wider social group. This makes sense when you consider most of the weddings you attend have anywhere from 100 to 300 people in attendance. Dunbar discovered the average size of our hunter-gatherer ancestors was roughly 148 individuals.^[18]

When social groups were this size, people could only compare themselves to others in their small tribe. Depending on your talents, you were bound to be the best at something, but humans were more worried about survival than keeping up with the Joneses. Technology and storytelling have changed all that. Homo sapiens were eventually able to create cities, religions, and companies with thousands and even millions of people through the art of storytelling. Going from hunter-gatherers to an agricultural source of food was the first major shift, while the printing press was the huge technological leap forward that allowed wide dissemination of these stories. The Internet is the printing press on steroids so it feels like it’s harder than ever to avoid trying to keep up with your neighbors, peers, friends, co-workers, or fake celebrities on Instagram.

While technology may ramp up our fascination with the Joneses, whoever they may be, you can take some comfort in the fact that the herd mentality has been around since long before likes, retweets, and influencers ruled social media.

Gustave Le Bon was a French psychologist who wrote the book The Crowd: A Study of the Popular Mind all the way back in 1895. The passage sums up his findings well:

The most striking peculiarity presented by a psychological crowd is the following: Whoever be the individuals that compose it, however like or unlike be their mode of life, their occupations, their character, or their intelligence, the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind that makes them feel, think and act in a manner quite different from that in which each individual of them would feel, think and act were he in a state of isolation. There are certain feelings that do not come into being, or do not transform themselves into acts, except in the case of individuals forming a crowd.^[19]

This work was written 175 years or so after the South Sea and Mississippi bubbles, but it sounds like it could have been written by a reporter who was on the streets of London or Paris witnessing the madness of the crowds going nuts for those companies. Le Bon’s passage would also be relevant to the roaring 20s in the lead-up to the Great Depression, the 1980s property and stock market mania in Japan, the dot-com bubble at the tail end of the 1990s, or the real estate bubble of the 2000s.

The markets, countries, and people change but the herd mentality is the one constant in all these situations. Once we surpassed Dunbar’s number and created modern society beyond the tribes of our ancestors, these situations became inevitable. Our brains simply aren’t hardwired to watch someone else get rich quickly if we’re not joining in the fun. This makes financial bubbles unavoidable. It also means Type II charlatans will always be there waiting to take advantage.