Most modern-day stock investors give little thought to the tulips they see popping up in yards and gardens every spring, except perhaps to muse, "Aren't those lovely?" Some -- like me and perhaps you -- are savvy enough to know that tulips should serve as a reminder to us investors of the dangers of speculation. Here's why, as I explained in a previous article:
While the pilgrims were settling down in Massachusetts, people in Holland were bidding higher and higher for tulip bulbs. This great "tulipmania" episode of the mid-1600s is one of the first documented cases of a speculative investing frenzy. Incredibly, people were taking out loans on their homes to buy bulbs they didn't even intend to plant, but to resell. Prices soared to the modern-day equivalent of tens of thousands of dollars per bulb. Eventually, the proverbial bubble burst, wiping out many investors.
That was most of what I knew of the matter -- until I read an interesting little book recently: Mike Dash's Tulipomania: The Story of the World's Most Coveted Flower & the Extraordinary Passions It Aroused.
First, the facts
Before going any further, it's important to appreciate the scale of this frenzy. At the peak, a single, highly prized tulip bulb was sold for 5,200 guilders -- at a time when a carpenter earned 250 guilders per year -- and carpenters weren't paupers then. When a large estate of high-quality bulbs was auctioned off in 1637, it raised an eye-popping total of 90,000 guilders. Think of that 250-guilder annual income as like $50,000 today, and 90,000 guilders turns into $18 million.
Permit me to now share some insights from Dash's book, as they relate to investing.
The best are rare
It turns out that generating lots of wonderful tulip bulbs is not a simple matter. To produce a winner, a true standout, you may need to spend years breeding it to that point. Once you have a tulip that others also prize as valuable, it takes many more years after that to multiply it into large numbers. So in the famous tulip market of yesteryear, it was easy to find bulbs of old strains, ones not so beautiful or valuable, but the finest specimens existed in only small quantities, thus making them hard to find and afford.
It's the same way with stocks, in many respects. There are thousands of stocks you can choose from when you're looking to build your portfolio. But for the best performance, you naturally want only the best performers. And those are relatively rare. A 1999 Kiplinger's article, for example, listed the best stocks of the 1990s. Topping the list was computer maker and Motley Fool Stock Advisor pick Dell
No. 6 on the list was America Online, now part of Stock Advisor recommendation Time Warner
Breeding and grafting
To create outstanding tulips (and other plants), one often takes several plants with certain excellent characteristics and puts them together. This can be done in the business world, too, as companies study other companies' business plans and see what practices they might be able to adapt and use, to improve themselves.
Another fascinating aspect of the tulip craze of yore is the degree of trust involved. When you buy a tulip bulb, it just looks like an unappetizing brown lump. To a great degree, you are trusting that the seller has sold you what he says he sold you. The proof will come in the spring, when that brown lump blooms. And if you've been had, by that time the seller may be long gone.
It's similar with stocks. A stock is a piece of paper representing a small share of ownership in a real business. Shareholders, to some degree, have to trust that management is providing accurate information on the company's progress. Our securities regulations in this nation encourage companies to be honest, but just think back to Enron -- that bulb turned out to be more of a turnip than a tulip. Many investors were badly burned.
Underdogs suffer most
In the 1600s, it was most often those of limited means who got into the tulip trade, speculating wildly. They did so because it offered them a rare, if remote, chance to increase their position in life. It was relatively easy to enter the business -- you just had to scrape up enough to buy a few bulbs and then sell them. Similarly today, poor people tend to buy the most lottery tickets, presumably because many see winning the lottery as one of the few ways they might better themselves. The lesson here is that ignorance is costly.
I owe, I owe .
What made the tulip craze get even worse was when people stopped trading actual bulbs in their hands and moved on to even more speculative transactions. They started trading bulbs that were still in the ground, so that what actually traded hands were pieces of paper, not the bulbs. This was the beginning of what we would today call futures trading. Traders could employ leverage, often making big profits without ever taking possession of any tulips. It also exposed traders to increased risk, which eventually bit them in the behind.
This is not unlike what happens when people invest heavily on margin today, by borrowing money from their brokerages. When things go their way, they make extra-big profits. When things go the other way, they suffer outsized losses.
Yet another development was that of companies formed to pool money in order to trade tulips. If you didn't have much, you might have been able to enter the market this way, owning partial shares in the company.
When the tulip bubble burst, it did so in a spectacular fashion. Within a few months, previously valuable tulips were suddenly worth, at most, just 5% of their previous value. Most tulips dropped in value by 99% -- or more. In America's great stock market crash of 1929, Dash's book notes, it took two years for stocks to fall to their lows, and even then, they retained, on average, about 20% of their peak value.
We never learn
The saddest lesson from this bit of history is that we never learn. After the tulip craze came a period of intense speculation among the Dutch over hyacinth bulbs, about 100 years later. Meanwhile, France experienced a dahlia craze in the 1830s. There were many other crazes, too. You might even have participated in one yourself -- the so-called "Internet bubble" of the late 1990s and early 2000s. Remember telecommunications specialist JDS Uniphase
Fortunately, you can decrease your odds of getting sucked into a speculative craze by educating yourself. Learn to focus on companies' intrinsic values, for example. Consider checking out one or more of our investing newsletters -- which offer education along with recommendations of promising stocks and mutual funds (and you can try them for free). Our Inside Value newsletter service, for example, looks expressly for undervalued firms, and it has found many standouts. Last time I checked, lead analyst Philip Durell's total average return was 11%, compared with 7% for the S&P 500 over the same period. Nine of his first 32 recommendations were up more than 20% since he recommended them, and five have advanced by more than 40%. How's that for a bloom on the rose?
Selena Maranjian 's favorite discussion boards include Book Club, Eclectic Library, and Card & Board Games. She owns shares of Time Warner. For more about Selena, view her bio and her profile. You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . The Motley Fool is Fools writing for Fools.