Building Wealth Doc's note: More than 300 years ago, Sir Isaac Newton fell victim to a classic case of "fear of missing out," or "FOMO."
In today's equivalent, Newton lost millions of dollars. But, as our founder Porter Stansberry explains, it's easy to avoid Newton's mistakes...
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No one wanted to be caught hanging out at Jonathan's Coffee House.
The unassuming shop – a hole in the wall in London's seedy Exchange Alley – was frequented by pickpockets and ladies of "easy virtue."
Even worse... it was also a den of stock traders.
In Exchange Alley, you minded your own business. So no one asked too many questions about the mysterious "Mr. Newton" who showed up one day... or suggested that maybe he shouldn't invest his entire fortune in shares of the South Sea Company.
So, despite his education and superhuman understanding of risk and numbers, Sir Isaac Newton fell for a classic economic bubble – just like countless other speculators over the centuries.
And we'll keep making those errors today... unless we understand how fads work and how to avoid them.
In 1719, the brilliant physicist, mathematician, and economist was pushing 80. He was also rich... and bored with his cushy government position as "Master of the Mint."
The South Sea Company – whose shares Newton bought – was a British joint-stock company founded in 1711. It mainly facilitated the slave trade between Africa and Spain's western colonies. But soon, it would branch out into other schemes.
When King George took over as the company's governor, shares soared. And by late 1719, Sir Isaac Newton had succumbed to the mania. He built up a position worth £13,000, equivalent to $2.5 million in today's money.
After buying in under £200 per share, he began selling the stock at £400 per share. He should have quit while he was ahead. But instead, he got caught up in phase two of the South Sea bubble... the Ponzi scheme.
In 1720, the South Sea Company pitched a program to convert British debt into South Sea shares. It proposed using the sale of new shares to pay down the £32 million in British government debt. Bribes flowed into Parliament to ensure the plan's acceptance... And company owners encouraged others to fuel the speculative bubble.
Newton got greedy. The Master of the Mint bought back in... at almost double the price he'd received as a seller months before.
Weeks after his new purchase, the stock price collapsed from more than £950 to less than £200.
By December 1720, Newton lost today's equivalent of millions. He'd discovered gravity decades earlier when an apple fell in his garden... But now, he'd learned painfully that the same principles held true in the stock market.
Today, you don't need a deep understanding of finance – or physics or astronomy – to spot investment fads. (As Newton regretfully acknowledged after the South Sea disaster: "I can calculate the motion of heavenly bodies, but not the madness of people.")
You simply need a strong mix of skepticism, market awareness... and knowledge of a few bright-red flags:
- Red Flag No. 1: Popular media outlets push the new trend. Media-sponsored events and "investment conferences" typically encourage investors to invest large sums immediately, pushing a combination of FOMO and promises of high, fast returns.
- Red Flag No. 2: The returns don't align with historically average market returns. Fads typically lack fundamentals, strong business models, revenue streams, and developed markets. Instead, they rely more on hype than substance.
- Red Flag No. 3: The "peanut gallery" is buzzing. Watch to see if people with a shallow knowledge of investing get excited about an opportunity. If your cousin – who can't balance a checkbook – starts trading Dogecoin on his cellphone, that's a bad sign.
- Red Flag No. 4: The business operators make bad decisions. In addition to the investment, you must look at the people who are operating the companies... and see if they have a weak track record or a history of failed ventures in various businesses. A person who was working in cannabis in 2019, move to angel investing in 2020, jumped to blockchain in 2021, and then ran a non-fungible-token ("NFT") company in 2022 probably isn't your ideal CEO.
- Red Flag No. 5: The regulators are cautious. If you can't spot fads independently, regulatory agencies like the U.S. Securities and Exchange Commission ("SEC") or Commodity Futures Trading Commission occasionally issue alerts about potential investment scams or fads.
As a master class in fads, consider one-time wunderkind investment manager Cathie Wood...
Wood has notoriously invested in unprofitable companies with terrible fundamentals. They usually do great... for a while... until they collapse. Wood's ARK Innovation Fund (ARKK) portfolio consists of tech wunderkinds like Coinbase (COIN), Roku (ROKU), and Zoom Video Communications (ZM).
Wood has argued that investors need to "wait five years" for ARK's investment to pay off. Yet it continues to burn through money in overhyped industries that still lack developed markets.
Another example of a recent fad is the wave of special purpose acquisition companies ("SPACs"). This fad has fueled dramatic losses, bankruptcies, and busts...
In 2020, the SPAC craze started with private companies merging with shell companies. The private companies could then go public without the hassle of an initial public offering. This included names like sports-gambling business DraftKings (DKNG) and electric-vehicle maker Lucid Group (LCID).
These companies were largely venture-capital-level investments with sky-high valuations in developing industries. Speculators went crazy for them. DraftKings surged more than 600%... before crashing back to Earth a year later.
In 2023 alone, 21 SPACs went bankrupt, according to Bloomberg. All told, those bankruptcies wiped out $46 billion in shareholder equity from their peak market capitalizations.
These aren't the only fads or bubbles of our lifetime, or the last... So remember: If it looks too good to be true, it likely is.
While the hype surrounding these "disruptive" sectors and speculative investments creates profits for some early investors, the downside risk is much larger than the short-term possibilities.
Focus on great companies with low debt, tangible assets, and strong capital efficiency – ones that return the maximum amount of cash possible to shareholders over a long period of years.
Regards,
Porter Stansberry
Editor's note: In 2015, Porter made a discovery which became his No. 1 recommendation of all time. And recently, Stansberry Research editor Whitney Tilson went on camera to share a breakthrough that he considers a must-have for investing based on Porter's discovery.
According to Whitney, "There's a way to make many times your money in this market... without taking on excessive risk, which – as you'll see – forms the basis of our breakthrough today."