Gold rushes tend to encourage impetuous investments. A few will pay off, but when the frenzy is behind us, we will look back incredulously at the wreckage of failed ventures and wonder, ‘Who funded those companies? What was going on in their minds? Was that just a mania at work?’

—Bill Gates

Glass was created millions of years ago when a comet struck the planet and emitted enough heat to create a chemical reaction that turned silicon dioxide into a liquid that changed into a solid as it cooled. But glass didn’t serve much of a purpose until another invention brought it to life. Johannes Gutenberg’s printing press led people across Europe to realize they were farsighted when they tried to read. Demand for reading glasses skyrocketed. This increase in demand led to a wave of innovation in other areas as scientists began to experiment with different lenses.

Lens experimentation led to the microscope, which literally opened our eyes to the inner workings of cells in the body. Then in the 1970s, researchers at Corning Glassworks developed an astonishingly clear type of glass. Scientists at Bell Labs took the fibers from that glass and sent laser beams down the length of the fibers using optical signals, which worked much like computer coding with zeroes and ones. Mashing these seemingly unrelated inventions together – clear glass with fibers and lasers – created what is now known as fiber optics. It turns out fiber optics are extremely efficient at sending electrical signals at a greater bandwidth than other cables. This efficiency makes fiber optic cables better at sending signals over long distances than the original copper cables used in the past. The Atlantic Ocean has ten different fiber optic cables which easily carry the bulk of our data and voice communications around the globe instantaneously. The cables are so efficient at handling signals that you could take all the voice and data traffic going back and forth between North America and Europe and hold it in the palm of your hand.^[1]

And it just so happens that this little thing called the Internet eventually came along, which required greater bandwidth that fiber optic cables could provide. So glass is now being used to transmit the information we consume every day on the little glass supercomputers we carry around in our pockets for work, play, entertainment, socializing, and wasting time. It’s highly likely that the infrastructure for this system would have taken a lot longer to put in place if it wasn’t for the dot-com bubble of the 1990s.

Bubbles evoke all sorts of stories about the madness of crowds and the eventual pain that follows during the inevitable crash. The dot-com bubble certainly led to plenty of madness and eventual losses as speculators tried to make sense of how far technological innovation could take things in what was being touted as the “New Economy.” Intel, Cisco, Microsoft, and Oracle, some of the biggest tech darlings of the 1990s, were worth a combined $83 billion at the outset of 1995. Just five short years later, as the tech bubble inflated to astronomical levels, this group had grown to a combined market cap of nearly $2 trillion! That was a gain of well over 2,100%, or 80% per year for five years. In 1999 alone 13 tech stocks were up 1,000% or more, including the biggest winner of them all, Qualcomm, which rose an astonishing 2,700%. Amazon was up 966% a year earlier.^[2]

The bubble finally popped in early-2000 when investors realized the fundamentals of these businesses couldn’t possibly live up to the insane growth priced into their share prices. Amazon was down close to 95%. Apple fell almost 80% in value while Cisco (down 86%), Intel (down 78%), Oracle (down 84%), Qualcomm (down 83%), and Microsoft (down 60%) all suffered similarly huge losses. Plenty of other stocks that went public in the 1990s completely went out of business, including the infamous Pets.com.

The outcome of this rollercoaster wasn’t all bad though. Too much competition for investment, overcapacity, and lofty expectations during a bubble can lead to enormous losses for those left holding the bag when the bubble eventually pops. But if some of that investment is used for productive purposes, it can lead to net gains for society when it’s put to use. Before the dot-com bubble popped, telecom companies raised almost $2 trillion in equity and $600 billion in debt from investors eager to bet on the future. These companies laid down more than 80 million miles of fiber optic cables, which represented more than three-quarters of all digital wiring installed in the US up to that point in all of history. There was so much overcapacity from this build-out that 85% of these fiber optic cables were still unused as of late-2005. And within four years of the end of the dot-com bubble, the cost of bandwidth had fallen by 90%. So despite more people coming online by the day during this period, costs fell and there was so much capacity available that those who were left standing were able to build out the Internet as we know it today.^[3]

Before trains can travel, you need to lay the tracks, which is a perfect segue into our next charlatan, George Hudson, and his role in the railway bubble of the nineteenth century.

The Railway Napoleon

Technological innovation isn’t a prerequisite for fraud to occur, but it sure makes it a whole lot easier. Innovation breeds change, change breeds emotion, and emotion adds fuel to the fire when money is involved. There’s a reason financial bubbles are often called manias – they elicit heightened levels of energy, excitement, and activity. Hucksters are drawn to financial manias like a millennial to avocado toast because it’s easier to deceive people when they think humanity is entering a “new era” or “paradigm shift.” Self-promoters take their hubris to another level to prey on the greed of others during these times. George Hudson saw the British railway bubble of the mid-nineteenth century as an opportune time to profit from the excitement in the air. There was a wave of innovation taking place, and the emotions of the crowd who were looking to get rich quickly led to one of the more underrated historical bubbles on record.

Like most bubbles, the railway mania actually started out as a good idea that was simply taken too far by investors and those selling railway projects alike. The first commuter trains appeared in the United Kingdom during the 1820s. They traveled just 12.5 miles per hour, which reduced the trip from London to Glasgow to 24 hours. The Railway Times asked, without even a hint of sarcasm, “What more could any reasonable man want?”^[4] The first railway mania hit in 1825 with the opening of the first steam railway. An economic downturn snuffed out any speculation and by 1840, shares of the main railway companies were selling at a discount to their issue price (stocks acted more like bonds than stocks back then). There were 2,000 miles of track completed at this point, which led some to speculate whether the national railway system in Britain was already finished.^[5]

Memories are short when people think there’s money to be made so this first mini-mania in railway stocks became a distant memory by the summer of 1842. That’s when Prince Albert of the Royal Family persuaded Queen Victoria to take her first train ride. That was the all-clear investors needed to hop aboard the train that was railway stocks. By 1844, investors viewed railway stocks as safe and secure with huge upside potential. It didn’t take long for that cautious optimism to morph into reckless speculation.^[6]

George Hudson was one of the original modern capitalists, using publicity, salesmanship, and a cult of personality to attract enormous amounts of capital and goodwill from the public. Best described by his contemporaries as energetic, abrasive, bullying, penny-pinching, rule-bending, and overweight, Hudson was a shrewd businessman who knew how to persuade people to do what was best for him and his companies.^[7] Innovation helped trains travel farther distances and carry heavier loads, so Hudson pounced on the opportunity by creating his own line of railways in the 1830s. Through a series of consolidations, mergers, schemes, bribes, acquisitions, and an uncanny ability to sell, his railways consolidated more power than any other in the railway industry, eventually creating the largest railway company in Britain. By 1844, Hudson oversaw one-third of the total tracks in operation, measuring over 1,000 miles in distance, quickly becoming chairman for a number of railway companies.^[8]

Company heads were not paid the astronomical sums CEOs can earn today, so Hudson became frustrated with how little he was getting paid for his work. So he decided to use his position of influence to make things happen on his own. Auditing was basically nonexistent at the time, which allowed Hudson and his directors to go nuts. And even if they wanted to challenge Hudson, none of the other directors had his level of knowledge or salesmanship. Not content to rest on his laurels or his morals, Hudson ruled with an iron fist. His M.O. was to act in complete secrecy by keeping his fellow directors and shareholders in the dark about the inner workings of his companies. This included a refusal to hold finance meetings, changes to accounting methods, and general obfuscation of the financial statements of the corporations he led. When Hudson joined the board of one railway company in 1842, his first order of business was announcing an immediate change to the company’s accounting methods, proclaiming, “I will have no statistics on my railway!”^[9] This is an obvious red flag, but when people are making money and change is afoot few pay any heed to red flags.

Nearly 500 new railway companies were in existence by the summer of 1845, with stock prices in the sector up a cool 500%. As share prices rose during the 1840s so too did Hudson’s bank account. The palatial estate he purchased at the entrance to Hyde Park was the largest private home in all of London. Hudson became synonymous with business success as the mere mention of his name by promoters provided enough credibility for the sale of stock on a new railway project. Hudson quickly became one of the most prominent figures in the social and political class of Great Britain in the nineteenth century through a combination of wealth, fame, and charisma.^[10]

Although he was skilled at selling, Hudson didn’t exactly have to twist anyone’s arm to invest in these new projects. Money was flowing in faster than Usain Bolt with the wind at his back. Investors of all shapes and sizes were basically throwing money at Hudson-backed railway projects, as optimism about the future of travel reached a fever pitch. By June 1945 the Board of Trade was considering over 8,000 miles of new railway, which was 4 times more than the existing system and almost 20 times the length of England. There were literally blueprints for tracks that started nowhere and went nowhere with no planned stops along the way. The estimated cost of the nearly 1,200 railways under consideration was more than £560 million. To put this number in perspective, that was more than the national income of the entire country!^[11]

The most mind-boggling aspect of all this money pouring in is that the source of capital was almost entirely private investors. This wasn’t the government investing in the infrastructure of their country but investors who were looking to get rich. As the railway bubble grew in size from overinvestment, Hudson’s self-control loosened. They even nicknamed him the ‘Railway Napoleon’ for his grandiose ideas and centralized decision-making process. To attract investors the railway companies offered fat dividend payments. The companies he ran were also known to see suspicious spikes in price the day before a takeover announcement, a clear sign of insider trading by Hudson and his fellow directors who had the knowledge in advance.^[12] This bubble also contained an accelerant in the form of a growing media presence.

The Media’s Role in a Bubble

Technological innovation not only makes people feel better about the prospects for the future, but it makes it easier for others to learn about what’s going on around them. Better access to news and information makes it easier for people to hear about others getting rich around them. The transition mechanism of spreading the gospel of FOMO is the media. In his book, Irrational Exuberance, Nobel Prize winner Robert Shiller says the news media adds fuel to the fire of herd-like thinking in a bubble:

Although the news media – newspapers, magazines, and broadcast media, along with their new outlets on the Internet – present themselves as detached observers of market events, they are themselves an integral part of their events. Significant market events generally occur only if there is similar thinking among large groups of people, and the news media are essential vehicles for the spread of ideas.^[13]

You can’t blame the media for every investment thesis that gets blown out of proportion, but it would be difficult to have bubbles if it weren’t for the free flow of information. This is why the information age is a double-edged sword. We have access to more information in a day than our ancestors saw in a lifetime, but that fire hose of information can often act as a deterrent to rational thought. The media often fans the flames of groupthink and confirmation bias.

There were just three railway journals at the outset of the 1840s, led by the Railway Times. By the time the mania reached its zenith in 1845, there were 14 biweekly railway papers, two daily editions, and one that was published every day in both the morning and the evening. Advertisements flooded the newspapers and periodicals. The media pounced on the Queen Victoria train ride, proclaiming railways as a revolutionary development for mankind, sparking interest from the public in all things rail travel. Hudson was far ahead of the game in terms of understanding the power of the press and how to use it to expand his empire. It helped that he had a financial interest in three newspapers who would all run flattering pieces on his railway projects to attract new investors. There is a rumor that Hudson even tried to support a radical new publication called the Daily News and have Charles Dickens as the editor. Dickens was not a fan of Hudson and supposedly remarked, “that he [Dickens] should be the last man in the world to be a supporter of it.”^[14]

The schemes worked like this: newspaper ads would promise a 10% dividend for anyone who put money into a new railway project. If the project got enough funding, the directors would hold onto a large allocation of shares in the newly formed corporation. This created enough scarcity to push up the price from the flood of new investors, which thereby allowed the directors to flood the market with their shares by selling at a premium price. George Hudson was a master at this scheme, promising unsustainable dividend yields of 50% to inflate the share prices on certain issues, which only encouraged more insider trading by himself and the company directors.^[15]

At the start of 1845, 16 new railway proposals were underway and over 50 new companies were formed to meet this demand. Those promoting these deals were highly underestimating the actual costs involved with these projects, often quoting the expenses at bare bones levels for engineering and materials alone, forsaking a staggering amount of ancillary costs. Expenses were purposefully understated to ensure the public would put up the money in the first place and deal with the ramifications and cost overruns later (or not at all once they flipped the shares for a profit). Actual costs turned out to be around twice what was estimated.^[16]

In my preparation for this chapter I read a ridiculously long research piece that sought to quantify what was being priced in by the rise in railway stock prices for variables like economic growth, profits, revenues, and the total addressable market of tracks and passengers. No one was doing this at the time. People don’t set baseline expectations during a mania. There were plenty of people at the time warning investors how unsustainable these fundamentals were, but no one wants to talk about fundamentals when there’s money to be made in the short term.

Because the media was so heavily involved in the mania, the public at large became by far the biggest investors in the bubble. In fact, Parliament published a report in the summer of 1845 revealing the identity of some 20,000 investors who had subscribed for at least £2,000 or more worth of railway stocks. Hudson’s name was on there, of course, but so were 157 members of Parliament and almost 260 clergymen.^[17] Investors included the likes of Charles Darwin, John Stuart Mill, and the Bronte sisters. Darwin is said to have lost up to 60% in the aftermath of the mania, which was actually much better than most fared in the bloodbath that followed.^[18] The rest were mostly regular people, showing how broad the speculation was. Many investors were subscribed for more shares than they could ever hope to pay for, but the idea was they would all have the chance to sell at a premium before getting all of their capital called in to create the actual railway projects. Most people assumed the greater fool theory applied, but no one planned on being the last fool standing. Rarely do investors have the timing or fortitude to turn the greater fool theory into a reality.

The mania was particularly strong in the suburbs because these were the areas that could see the biggest impact from the infrastructure build-out from the new train tracks. In one town, there was a group of stockbrokers who would take an express train twice a day to relay information from one town to the next on the latest changes in share prices for the railway stocks. Practically all the money for construction of the railways came from individuals. By 1850, the amount invested was around £250 million, almost half the GDP of Great Britain at the time, the equivalent of roughly $1.25 trillion for the UK today (or almost $10 trillion for the US in today’s terms).^[19]

The Other Side

Rising interest rates were the first pinprick in the railway bubble in the summer of 1845. But there were still a record number of Railway Bills in Parliament’s 1846 session than ever before or ever since. The appetite for projects remained even after share prices began to dip. There’s an old saying that markets take the stairs up but the elevator down, and the railway stocks were no different. Increased competition and overinvestment finally brought these companies back to earth. Bankruptcies hit an all-time high in 1846, just a year after the height of the mania. People from all walks of life and levels of wealth were ruined. By the start of 1850, railway share prices had fallen an astronomical 85% on average.^[20]

By 1849, Hudson’s role as Railway King came to an unceremonious end. Four of the railway companies he was heavily involved in were under investigation. The shady personal transactions, embezzlement of company funds, overstating of profits, bribing members of Parliament to push his projects through, and insider trading schemes were all made public. The 12 reports produced about his business dealings forever changed public perception of the once revered businessman. The high society Hudson so eagerly sought to be a part of immediately turned their back on him. Hudson was never prosecuted in a court of law because securities laws at the time didn’t protect shareholders the way they do now. But he was tried and convicted in the court of public opinion and ostracized by the elite class, which may have been even more of a blow to his gigantic ego.^[21]

The press sang Hudson’s praises when things were going well but turned their back on him when things went awry. The Railway Times published what was basically his business obituary, but they also came down hard on the investors who went along for the ride:

He no more caused the railway mania than Napoleon caused the French Revolution. He was its child, its ornaments, and its boast. His talent for organisation was prodigious. No labour or speculation seemed too vast for his powers. He combined and systematised the attacks of a hundred bands upon the public purse; he raised all the fares, he lowered the speed, he reduced the establishments, he ‘cooked’ all the reports, and he trebled all the shares. The shareholders wanted their dividends doubled, and their shares raised to a proportionate market value. They never calculated the extent to which these achievements were honestly practicable, or considered the measures to which it would be necessary to resort. They wanted the trick done all at once and Hudson was the man to do it.^[22]

Hudson was able to stay afloat in political life for a few years after the bubble had burst but was eventually arrested for not paying his debts and died broke a number of years later.

The Silver Lining of a Market Crash

A large number of tech start-ups with seemingly good ideas went out of business after the dot-com flameout. But that era planted the seeds for the next wave of innovation that occurred, which gave us services like YouTube, Facebook, Twitter, and Google. Venture capitalist Marc Andreessen said, “All those ideas are working today. I can’t think of a single idea from that era that isn’t working today.”^[23]

The railway boom and bust had some positive outcomes as well. Not all was lost from this period of untamed speculation, greed, and accounting fraud. By 1855, there were over 8,000 miles of railroad track in operation, giving Britain the highest density of railroad tracks in the world, measuring seven times the length of France or Germany. The railways set up during the bubble years came to represent 90% of the total length of the current British railway system. People and businesses across the country experienced massive gains in efficiency through cheaper and faster transportation of raw materials, finished products, and passengers. And during the 1840s more than half a million people were employed by the railway companies to make those tracks a reality. Tens of thousands of people from Ireland were provided employment throughout the famine years. In many ways, this was a wealth transfer from rich and middle-class speculators to the labor class that simultaneously provided the country with much needed transportation infrastructure.^[24]

News distribution spread, and the capital markets became more mature. New stock markets were set up in cities all across the country. Stock brokerage firms grew from 6 in 1830 to almost 30 by 1847. There was greater innovation during the industrial revolution of the eighteenth century but the railway boom required far more capital, and thus investors. This changed the way the middle class thought about investing its money.^[25]

The problem for those trying to handicap the financial ramifications of this type of innovation is that the economic impact doesn’t always occur at the same speed. Investors extrapolate innovation indefinitely into the future, carrying prices too far, too fast. It took time for the combustible engine to completely replace the horse and carriage. The promises of the Internet almost all came true, but we first had to go through the crash and a number of lean years to get there. Excitement pervades when new technologies are released. Most of the early car companies flamed out. When car ownership first took off in the 1920s there were 108 automakers in the US. By the 1950s, they had been whittled down to the big three that produced the majority of cars.^[26] The entire airline industry basically lost money or went out of business in the century after air travel was invented.

But investors are so enthusiastic they never stop to wonder what could go wrong, only how the world could change, and more importantly, how rich they could become in the process. The siren song of innovation means there will invariably be a new gold rush every time we collectively get excited about a shiny new object. Those innovations may change the way we live but that doesn’t necessarily mean they’re going to make you wealthy in the process.

Innovation is one of the many ingredients for fraud to occur. In the next chapter we’ll look at how even an outdated product can cause people to collectively lose their minds during a fraud of epic proportions.