Hindsight is easy – any person can point at a chart in retrospect, draw two arrows for where you should have bought and sold to make the maximum profit, and pretend to look smart. Real trading happens at the ‘right side’ of the chart, where new data appears in real time and the future is unknown.
However, that does not mean looking at the past does not serve a purpose. When developing strategies, or when desiring to improve your trading, it becomes necessary to look back and see how things would have worked out, and what events led to what outcomes how frequently. Usually this is done on data from the last decade or so at best, but why not take a (much) further step to demonstrate that the basic tenets of speculation are as old as the hills?
Call it an exercise in futility, glory in hindsight … but wouldn’t it be interesting to see how one could have made money a very long time ago using principles still valid today? Let’s take a step into the time machine and jump back to … 1720 – A year known in financial circles for a time of exuberance dubbed as the South Sea Bubble.
The South Sea Company
Home to possibly the world’s first Ponzi scheme, this bubble is set in times when the South Sea Company (SSC) was formed as a British public-private partnership and granted a monopoly on trading African slaves with the Spanish and Portuguese Empires.
What a business model – but hey, you have to go with the times. Slaves were the rage back in the day, and such joint-stock companies (similar to today’s corporations) were not a rarity back then in England. Think of the notorious East India Company, and even Sir Francis Drake’s “privateering” of Spanish commerce vessels had been financed via one, counting Queen Elizabeth I among its shareholders.
In exchange for this monopoly, the SSC was given the unassuming task of consolidating and reducing the national debt, while increasing Britain’s trade in the Americas.
SSC stock was thus backed by government bonds, and stockholders were offered excessive interest on those bonds. Reportedly, parliament expected stock sales to service the growing payments. Starting to sound fishy?
It gets worse. Though the SSC brought roughly 65,000 slaves to Spanish America over the years, a projected trade explosion never manifested due to hefty Spanish trade restrictions of and taxation on British trade after the treaty of Utrecht. Despite great expectations, and even dabbling in side hustles such as Arctic whale-fishing, the SSC never turned a real profit.
Company management though saw this fact as merely a minor and negligible roadblock, and kept it from the public – instead, the SSC turned its own stock over vigorously, bribed officials, spread rumors to engineer publicity and keep demand high, allowed stock purchase with low or no down-payment, and got the Kardashians of the day (the aristocracy, ranging from the Duchess of Kendall to the House of Lords) to vouch for the stock, illegally offering them gifts and favors in return. Once the ruling monarch George I took nominal leadership of the company, stock certificates promised as much as 100% interest.
A great blue-print for running a fraud scheme, it seems, as stock prices skyrocketed from below £100 to almost £1000 in a few months. This was mirrored by a bunch of other securities rallying in parallel, many of which were equally fraudulent, courtesy of sentiment spillover.
Of course, eventually the news leaked out and spread. Prices imploded and stock certificates (image below) quickly fell at a painful pace, making the SSC an extraordinary poster child – that is, if you ever wanted to learn how to cause financial ruin to stockholders, suicides, and public outrage. A later investigation revealed the widespread corruption, and resulted in a political and financial scandal – but let’s be real, I believe most people must have known something was off at some point, because it was just too good to be true.
Of physicists and gamblers
Analyzing a stock chart of the SSC stock at the time, though looking impressive at first glance, comes with certain caveats – there is no recorded trading volume data, there are data gaps that require extrapolation, and neither is any surviving Open/High/Low/Close data available. We’ll have to make do with the little there is.
Below is a simplified line chart of the rollercoaster rally in SSC share price spanning 1719 – 1721. This bubble has become somewhat of a popular anecdote in financial textbooks discussing manias and crashes, because none other than the famous Brit Isaac Newton tried to get rich quick with it and fell for the ‘too good to be true’.
As you can see in the annotated chart below, your status as an eminent academic in physics, or a high IQ in itself for that matter, is not enough to drive smart decision-making in the stock market. If you go in without an established plan and a contingency and rule for anything & everything that might happen, you invite emotions, impulses and self-destructive behaviors to come to the fore.
Isaac fell for many of the classical mistakes – buying on a tip, discussing his positions in with his peers in social settings, having no pristine entry and exit rules, averaging down, and letting impulses take over decision-making. In short, he became a gambler … and gamblers are apt to take a bath eventually.
After an initial soft rally in the stock, he and some of his acquaintances started dabbling in with a little money. Isaac got cold feet once the stock dipped somewhat after a good rally, and sold his shares in the ballpark of a 100% gain once price came back to the old highs made – typical shareholder psychology involved in the formation of chart patterns.
After the stock continued rallying strongly thereafter, and seeing his friends’ money grow while being left in the dust, he decided to double down out of the old fear of missing out. He rebought his shares and a much larger portion on top once the stock had become highly extended and buyers were exhausting themselves. Holders were starting to take profits, selling started to abound, and Isaac didn’t realize that he was buying near what would be the final top. One of Isaac’s famous laws of Newtonian mechanics is ‘actio est reactio‘, i.e. to every action there is always opposed an equal reaction. Or, in market terminology, what goes up phenomenally will eventually come down phenomenally.
After the bad news broke and the stock sold off, regret, anger, hope and pleading – rather than objective exit rules – made him hold his stock into oblivion. Reportedly, he lost 20,000 British pounds – adjusting for change in purchasing power, roughly 5 million pounds of today’s money. “I can calculate the motion of heavenly bodies, but not the madness of people“, he was later credited with remarking. Many shareholders that were attracted to the stock like Isaac near the top experienced total financial ruin during this crash, and only few would count himself among the lucky few that got away with merely a black eye and a valuable lesson.
Let’s try again
How could Isaac have traded SSC stock more efficiently, for a larger return on limited risk, without giving back his profits? As mentioned above, the existence and application of a strict set of rules would have helped. Due to the coarse data of the line chart we can only approximately assess an exit point using conservative selling rules. However, such an approximation is still sufficient to make the point – that Isaac could’ve made good money if he would have been serious about it.
Below annotated is a trading plan for SSC stock using principles derived from the greatest stock traders of the last century and beyond:
- A “good speculator” Isaac would have sat out the initial rally to get confirmation of the stock’s strength, and awaited a low-risk entry point.
- Once the price advance had digested, Isaac should have entered the stock for the first time at about the point where he sold his lot.
- Rather than buying a minimal portion without risk management, he should have bought a relatively more sizable portion and applied strict risk management.
- From this buy point, the stock rallied roughly 280%, with a conservative application of exit rules allowing for a realizable 235% profit – in relative terms, more than 2.3-fold of what Isaac’s initial dabbling efforts brought about.
- Some of such stocks offer multiple low-risk entry points, marking genuine times to “double up”. But recognizing genuine and constructive ones from false ones can be tricky.
The details of Isaac’s involvement and his actual transactions remain subject of debate to this day. However, the general assumptions appear valid (here an article on the topic) and represent a believable story. Because if one thing is for sure, it is that scientists, accountants, academics and even economists make for the worst traders – because they tend to bet all chips on their own intelligence and education while paying no heed to the vital importance of emotional discipline and managing odds & risk.
As for the trading example above, as the saying goes, hindsight is of course 20/20. But does that mean that we can’t learn from history, Isaac’s mistakes and what little data there is to aid in developing blue-prints on how to recognize and handle future super-stocks? Hell no!
Feel free to check out my other Short Letters to learn more about other common amateur mistakes and how to avoid them, or jump right into the nitty-gritty of becoming a successful speculator in the educational section.
So long, TGS
