Sir Isaac Newton’s Biggest Mistake

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“I can calculate the movement of stars, but not the madness of men.” ~ Sir Isaac Newton (after losing a fortune in a stock bubble)

 

Sir Isaac Newton (1643 – 1727) is famous for his discovery of the laws of gravity and motion.  He is less well known for losing a fortune in the stock market.  But a look at Sir Isaac’s investing mistake provides an invaluable lesson for investors today, namely how to avoid losing serious amounts of money in an investment bubble.

 

When it comes to investing, we really are our own worst enemies.  Our emotions get in the way and cause us to make highly irrational choices that are disastrous to our wealth.  In our post from last week, we wrote about herding behavior, its psychological implications, and how it leads us to make extremely poor investment choices.  This week, we’ll focus on asset price bubbles, one of the main results of herding behavior.  But first, let’s take a closer look at Sir Isaac Newton.

 

Back in Newton’s day, the British fought in the War of the Spanish Succession.  In order to finance its debt from the war, the British government awarded a monopoly on trade with the Spanish South American colonies to the South Sea Company in return for the South Sea Company assuming its war debts.  The South Sea Company listed on the British stock exchange and caused one of the most well-known investment bubbles of all time.  In fact, the South Sea Bubble is the original use of the word bubble to describe a speculative run-up in the price of an asset that eventually crashes.  Sir Isaac Newton was not immune to the lure of the South Sea Company stock.  He invested early in the trend and cashed out after making a substantial gain.  However, the price continued to rise and his friends made money.  Greed got the best of him.  He went in with a massive investment at a much higher price and then subsequently lost almost his entire fortune (£20,000 at the time, today equivalent to about £3m) when the bubble collapsed.   He reportedly, until his death, forbade people to mention the South Sea Company in his presence.  The chart below shows how this played out for Sir Isaac:

 

pst_newton south sea bubble

 

Every bubble starts with a compelling underlying thesis.  In most recent times we have witnessed two major bubbles, the dotcom bubble and a few years later the real estate bubble, which caused the 2008/09 financial crisis.  The compelling thesis that starts all popular investment trends becomes stretched as prices increase and eventually the underlying thesis and actual value of the investment become completely disregarded as investors create a speculative frenzy.  The bubble then bursts and prices collapse.  A few early investors and well-timed speculators make a fortune, but the majority of investors lose their shirts, just like Isaac Newton.

 

Today, after 8 years of central bank’s quantitative easing, interest rates are at a record low worldwide.  Record low interest rates have caused bubbles across many different asset classes.  Bubbles are prevalent in now in bonds, real estate, and equities, but also in more esoteric asset classes like art, classic cars, and rare wines.  The “Fed Put” as some have called it, means that you can go long anything because the Fed (or your central bank of choice these days) is going to be there to support asset prices when things start to falter.  The Fed Put has worked really well for the last eight years, but it is starting to lose it potency.  Asset prices are unhinged from rational valuation levels and seem to be topping out in many asset categories.  Likely this could be the point where the cycle is starting to turn.

 

This is a very dangerous time to be investing.  It is very easy to get taken in by the ease in which many of our fellow men and women have made a lot of money in the last several years.  You might be thinking, “these people are not that bright and they just made a ton of money in real estate, or that guy I know just doubled his money on a classic car, I should give it a try.”  Yet, in this exact moment when the gains seem so easy, this is when we must exercise the highest degree of emotional restraint in order to produce good long-term investment outcomes.

 

The solutions for overvalued assets across pretty much every segment of the investing world fall broadly into several categories:

  • We can go to cash and wait for the crash. This approach seems simple on the surface but it has several issues:
    1. It is very difficult emotionally to move directly into cash for long periods of time, especially when the central banks are trying so hard to devalue the currency, which we worked so hard to earn in the first place. What if it takes another year or two for asset prices to deflate?  Will you be able to hang on?
    2. How are you going to know how to time the bottom? No one can consistently pick the bottom.  You might think prices look attractive only to dive in and see prices fall another 30% and stay there, for years.  (If you don’t believe this will happen pull up a 30 year chart of the Nikkei 225 Index).  Or, you might be waiting for prices to reach a certain level of attractiveness to go in, and it never happens.  The recovery starts before you get in, and you miss another eight years of investment gains.
  • You can sell your assets and buy gold, or some other commodity that you think cannot be debased. This approach seems to make sense, but also has some issues:
    1. Gold has no industrial use that defines its value, so you are making a speculative bet that may not go your way.
    2. All other issues about taking profit, stop losses, and knowing when to switch from this asset class back into your normal investments also apply.
  • We can hedge our bets. That way, we can participate in further gains should they occur and lose less should the market dive.

 

As you may gather from our past writing, given all the unpredictability involved in the world of investing, we would choose the third path.  There are so many risks, unknowns and emotional issues to overcome with the first two approaches, that even the best investors have trouble executing on those effectively.  For traditional investors we would recommend an approach, similar to that taken in our Smart Wealth portfolios, whereby we have an element of embedded downside protection.  That helps create better returns over an investment cycle with less volatility and reduces the risk that we will act irrationally and lose money should a bubble burst.

 

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