This article is an excerpt from the Shortform book guide to "A Random Walk Down Wall Street" by Burton G. Malkiel. Shortform has the world's best summaries and analyses of books you should be reading.
Like this article? Sign up for a free trial here.
What was the tulip craze? How could flowers become so valuable in such a short space of time?
The tulip craze in 17th-century Holland is widely known as the very first economic bubble. The price of tulips escalated so much that people sold their valuables to buy tulips, and could buy assets like houses with them. This might seem absurd, but here’s an explanation of what happened.
Learn more about the tulip craze below.
The Tulip Craze: What Went Wrong?
The tulip craze in 17th-Century Holland is often referred to as the first economic bubble in history. Here’s why castle-in-the-air thinking might be to blame.
The castle-in-the-air theory of asset valuation holds that an asset is only worth what someone else will pay for it. In other words, no asset has an “intrinsic value” that can be determined analytically or mathematically; rather, the value of an asset is purely psychological—it’s worth whatever the majority of investors think it’s worth.
A castle-in-the-air investor makes her money by investing in stocks she thinks other investors will value.
Speculative bubbles, of course, are examples of the castle-in-the-air theory run amok. In a bubble, investors completely disregard the intrinsic value of a stock for fantastical notions of assets’ values, often with disastrous results. And while some investors are savvy enough—or lucky enough—to sell just before the crash comes, most are left holding the bag.
Here’s a deeper look at the very first economic bubble in history:
An In-Depth Look
Arguably the most famous—or infamous—speculative bubble in history, the tulip craze that struck 17th-century Holland perfectly illustrates the dangers of castle-in-the-air investing.
The tulip craze centered on specific bulbs, called “bizarres” by the Dutch, that were infected with a nonfatal virus that caused the petals to develop vivid colors and patterns. The demand for these striking flowers caused tulip merchants to buy bulbs in bulk, which resulted in a rise in prices and attracted value investors as well as speculators. The tulip craze became self-perpetuating: Prices continued to rise due to ever greater investment, which led to even higher prices and then even more investment. In 1634–1637, the years just before the crash, people began bartering valuables like jewelry and land to buy tulip bulbs.
Adding to the speculative frenzy was the “call option,” a financial instrument that allowed investors to buy bulbs at a fixed price (plus a premium) during a certain period and then sell the bulbs later for a profit. Options enabled less-well-off investors to enter the market: These investors could buy an option on a tulip bulb, say for $100, and fork over a $20 premium. If the price rose to $200 in the defined period, the option holder could exercise the option and sell the bulbs immediately, clearing $80 ($200 minus $120).
Although some economic historians, including Peter Garber, have attempted to argue that prices during the tulip craze were rational, few can justify the 20x increase in tulip-bulb prices that occurred in January 1637—or the equivalent crash in prices the very next month. Simply put, once the mania abated, the tulips’ lack of intrinsic value became manifest and prices plummeted.
———End of Preview———
Like what you just read? Read the rest of the world's best book summary and analysis of Burton G. Malkiel's "A Random Walk Down Wall Street" at Shortform.
Here's what you'll find in our full A Random Walk Down Wall Street summary:
- A comprehensive and entertaining introduction to the world of finance
- Practical investment principles that work for every skill level
- The advantages of index investing