How much would you pay for a stalk of tulip? If you haven’t heard of the Tulip Craze in the 17th century, it might surprise you how much people were willing to pay for a stalk of tulip.
Courtesy of commons.wikimedia.org
The Tulip Craze takes us back to 17th century Holland when speculators were interested in tulips (the underlying asset) only for its potential appreciation in value. Tulips are very beautiful and delicate. They blossom for only a few weeks between March and May. During this time, they cannot be uprooted until it becomes a bulb and retreats back into the ground completely. Between June and September, the flowers can be moved safely and planted in Autumn so that they can blossom again during Spring the following year.
Tulip speculators weren’t trading the physical tulips because uprooting the flowers at the wrong time would cause them to perish. Hence, they traded tulips based off a financial derivative called a futures contract. Similar to how commodities are being traded today, a futures contract determines a specific price the underlying asset will be transacted at, with the delivery of goods and payment made at a later date.
Courtesy of managedfuturesinvesting.com
A speculator would buy these contracts and sell them to another willing buyer at a higher price. The prices of these tulip futures contracts were bid up so high that they cost as much as some of the grandest houses in Amsterdam at that time. This buying frenzy was the epitome of “buy high and sell higher”, or as Burton Malkiel famously puts it in his book A Random Walk Down Wall Street, building “castles in the air”. In a case of severe optimism where prices rise sharply, there can only be one impending outcome to end it all; when even the richest of speculators are not willing to pay for it. Much like how the last person will not get a seat in the game of musical chairs, the last willing buyer who paid top dollar for the futures contract will not find another willing buyer to sell to at a higher price. This last willing buyer (now seller) would have to drop his offer lower and lower until it matches a willing buyer. Speculators who realized that prices may have peaked sold their contracts to “cash-out” for a profit. As you would have guessed, the tulip craze ended with a massive selloff as sellers frantically sold off their futures contracts before settlement (delivery of goods and payment) date. A tulip futures contract costing as much as a grand house was now worth almost zero.
While the Tulip Craze happened more than 400 years ago, it still has great relevance to the capital markets we operate in today. The dot-com bubble at the start of the 21st century is evident that the human tendencies of “greed and fear” have always been a big part of the market mechanism. I never liked being the last one without a seat in musical chairs, nobody does. So do we stay completely out of the market to prevent ourselves from being scathed from a crash? Or should we participate in the market but exit prematurely at the earliest sign of a peak? Could dollar-cost averaging be a better strategy since we can acquire the assets at a lower cost basis and remove the element of precise market timing? I don’t have the conclusive answer for you. You do, with due diligence of course!
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Till next week, have a good weekend!
Feature image – Courtesy of pixabay.com