The 1920’s were a time of prosperity in America. The stock market grew at a rapid rate over this decade. This increase provided many investors with high profits. Wall street exploited the growth of the market during this decade. A significant amount of money in the market contributed to the rapid growth of the common stocks. However, this prosperity led to a massive crash in the market.
The large bull market of the 1920’s created the Great Depression. Investors chased rising stock prices. Major banks on Wall Street gambled with their investments. Eventually, these gambles drove stock prices to dangerously high levels. Investors took risks purchasing these growing stocks. Mathematical valuation of the stock prices did not occur. These investors wanted to make a quick profit by trading these growing stocks. They disregarded the fundamentals of valuing these companies and began to speculate.
Speculation is basing decisions on instinct alone. Investing is different because it promotes the use of technical analysis to make decisions. These stocks eventually crashed because they were earning less money than their value. The 1929 crash demonstrates irrational decisions based on instinct. This event showcases the dangers of irrational investing in the stock market.
Image Source: http://www.mattwardman.com/blog/wp-content/uploads/spl3155wall-street-crash-posters.jpg
Technology stocks experienced a significant increase in value during the 1990’s. A large interest in the Internet and new technologies aided this price increase. People in this era looked for new Internet companies that held promise of a large increase in profit. However, Internet stocks lost significant value after their rapid increase. “During the 1990’s, Internet-related businesses were viewed as a way for investors to make quick profits, and millions of dollars were pumped into nascent businesses (American Business).”
As with previous market frenzies in history, these stocks became over priced and eventually collapsed. The United States economy experienced a downfall through these internet companies because many of the companies were unable to successfully profit. A few Internet companies sustained in the industry, but their competitors were forced to bankruptcy.
The dot-com bubble signified another instance of irrationality in investors. Investors only gambled on the consistant rise of Internet companies. These gambles led to an idealistic price increase. This idealism was refuted when the market took a downturn in the new century.
Quote Source: Heiney, James. “Dot-com Bubble.” American Business, U.S. Business, United States Business. Web. 16 Mar. 2011. http://american-business.org/2450-dot-com-bubble.html
Image Source: http://indiamicrofinance.com/files/2010/06/dotcom-bubble-2000.png
In the 17th century, Holland experienced a large bubble created by the price of tulip bulbs. This bubble provides an example of a market movement driven by investor speculation. Initially, tulip bulbs gained commercial interest as a household commodity. This interest evolved into an overpriced tulip market.
Due to a disease, these bulbs developed mutations that provided rare color combinations in the tulips (Malkiel, 35). “In a short time, popular taste dictated that the more bizarre a bulb, the greater the cost of owning it (Malkiel, 35).” The population in Holland began valuing the bulbs as a luxurious commodity. The tulip bulb’s price exponentially grew over the next year. Citizens of Holland believed the bulb to be a safe investment. People made fortunes by selling these rare bulbs at a high price.
However, the price of the bulb eventually plummeted. “Apparently, as happens in speculative crazes, prices eventually got so high that some people decided they would be prudent and sell their bulbs. Soon others followed suit. Like a snowball rolling downhill, bulb deflation grew at an increasingly rapid pace, and in no time panic reigned (Malkiel, 37).” This plummet occurred by the rapid selling of tulip bulbs. The public followed this speculative selling trend. Within the next year, tulip bulbs were worthless.
The tulip mania in Holland details the destructive nature of market movements. People have the power to manipulate market prices. This power is demonstrated in many other instances throughout history.
Work Cited from Novel: Malkiel, Burton Gordon. “The Madness of Crowds.” A Random Walk down Wall Street: the Time-tested Strategy for Successful Investing. New York: W.W. Norton, 2007. 35-37.
Image source: http://www.minyanville.com/assets/Image/tulipmania.jpg
Imagine walking into a grocery store to purchase a can of Coca-cola. At most stores, Coca-Cola costs 1 dollar. However, this store charges 15 dollars for the Coca-Cola. Would you purchase this expensive can of Coca-Cola? Most of the public would not purchase the 15 dollar Coca-Cola. A consumer usually decides the 15 dollar Coca-Cola is overpriced. Unfortunately, this concept does not always translate into the financial system.
The public regularly purchases stocks that are valued at a price much higher than the company earns. In short, people tend to purchase stocks without evaluating the price they are paying for the stock. This reasoning leads to a false increase in price. Eventually, a stock will reach an extreme price level. This extreme price level will cause a crash because the earnings for the company will not match the price of the stock.
The most important theory discussed by Benjamin Graham, author of The Intelligent Investor, is the theory of value purchasing. Value purchasing focuses on stocks with a low price to earnings ratio. A stock has better value when the price to earnings ratio is closer to one. This idea is true because the stock price reflects the company’s earnings more clearly. A price to earnings ratio of one is rarely seen. In these markets, a price to earnings ratio below fifteen is usually seen as a value purchase.
People demonstrate irrational behavior by overpaying for a stock. Purchasing a stock should be executed on a intellectual investment basis. Overpaying for a stock is similar to overpaying for a can of Coca-Cola. This overpayment drives markets to high price levels. In the words of Benjamin Graham, “Most of the time stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble … to give way to hope, fear and greed.”
Would you pay for the 15 dollar Coca-Cola, or wait to find a 1 dollar Coca-Cola?
Image Source: http://blog.reblace.com/?p=35
Quote Source: http://www.investopedia.com/university/greatest/benjamingraham.asp
Welcome to my blog, “Historical Market Movements.” My name is Will Soukup, and I am currently a sophomore at The University of Texas at Austin. I am studying Finance in the McCombs School of Business, and hoping to pursue a career in investment banking or investment management. This blog is going to focus on how irrational financial decisions can drive the financial markets. If you are interested in finance or investing, this blog will provide historical diagnosis of market moves and how financial decisions fuel these movements.
Specifically, this blog will touch on theories of behavioral economics and past market bubbles. Past events in history can’t predict the future of the stock market, but it can help provide a basis of reasoning when judging the effect of economic events. Investment bankers and hedge fund managers are constantly studying the past effects of events on the market, and the behaviors behind these effects. When a similar situation is presented, these professionals have an edge with deciding their next investment. I hope to help improve your future financial decisions, and present interesting stories about the history of the stock market. Please feel free to comment and provide feedback on any topic that interests you.
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