This article first appeared in Professional Adviser

Why you should be careful where you invest.

As bitcoin booms, Simon Goldthorpe revisits some historical investment bubbles including the Victorian rush to locomotives and the first futures market in tulip bulbs…

If you’ve been paying any attention to the headlines at all these last few months, you’ll be aware of the latest ‘boom’ in bitcoin.

You might have first heard about the cryptoasset in December 2017, when its value surged to almost $20,000 per coin. And although its price fell sharply in the months that followed, it’s recently grown to over double that amount.

They say that those who don’t learn from history are doomed to repeat it. So I thought it might be time to look at some historical parallels and see what we can learn about the bitcoin bubble.

‘Tulip mania’: the first financial bubble?

When bitcoin’s explosive rise in value first came to my attention, what also sprang to mind was not something new and revolutionary, but the so-called ‘tulip mania’ of the 17^th century.

At the time, the Dutch Republic had some of the most sophisticated financial institutions in Europe (if not the world), including the first official stock exchange, capital market and central bank.

This advanced financial system encouraged investment and trade in ways that had never been seen before, and one of the innovations that resulted was the formal trading of futures.

Unfortunately for the Dutch, all new ideas have teething trouble, and when merchants began trading futures of tulip bulbs – a luxury commodity at the time – a bubble quickly began to form.

Supposedly, at the height of the frenzy, futures contracts for tulips were exchanged as many as ten times per day, driving their price up, often to several dozen times their intrinsic value.

Of course, the bubble couldn’t last forever and when it popped, the price collapsed overnight. Merchants who had sold their houses for a slice of the action suddenly found themselves completely empty-handed, and theirs is a tale whose cautionary lessons should still be heeded by investors today.

There’s certainly a parallel with the crypto crash of 2018 when the price of bitcoin plunged 80% between January and September. Once again, a bubble had burst and dealt a heavy blow to the casual investors who had bought in late – many of whom had only heard about bitcoin when it hit the national headlines.

The same thing happened recently with struggling US retailer GameStop, whose vastly inflated share price tumbled after a week of breathless, ill-informed investment. And as bitcoin climbs to brand new heights, one can’t avoid a very worrying sense of déjà vu.

Tracing the market conditions of today in the railway boom of the 1840s

Tulip-mania is an excellent example of commodity speculation gone wrong, but there are many useful bad examples of business speculation, too.

According to a recent article in Forbes, Tesla trades at fifteen times its projected 2021 revenue and 175 times its projected earnings. While the firm may well play an important role in the future of clean energy, one has to question whether its stock may still be somewhat overinflated.

Here, too, we have a telling historical precedent ­- in this case, the railway-mania of the Victorian era, when the market conditions and makeup of investors were broadly similar to those of today.

The mid-19^th century was a period of particularly low UK interest rates, which made gilts – the go-to investment for many affluent Victorians – much less attractive than they had been previously. Furthermore, the industrialisation of Britain had created a strong middle class, who had capital to invest and financial knowledge to make informed decisions.

When the Liverpool and Manchester Railway opened in 1830, it was an undeniable commercial success and prompted a flurry of similar applications for the building of additional lines. In 1843, there were 63 applications to Parliament; in 1844, there were 199; and by the end of 1845, there were another 562.

This new and exciting investment attracted many members of the middle class, whose confidence was buoyed by the continued success of the original line from Liverpool to Manchester.

However, when many smaller railways were found to be commercially unviable, consumer confidence evaporated and their stock prices fell accordingly. Once again, the bubble burst, leaving legions of investors empty-handed.

Tesla shares have risen by more than 700% in the past two years, but in the same period, they have also reduced their earnings forecasts for every year from 2020 to 2024.

This has led some analysts to question whether its stock is simply surging on ‘speculative fervour’ – in which case, prospective investors should take care to consider the risks of buying in.

Studying bubbles

Studying previous bubbles is a useful way to avoid exposing yourself to excessive risk. It’s easy to spot a financial bubble with hindsight, but less so when you’re living through one.

For instance, Tesla’s stock price surge in recent years may not be backed by a corresponding increase in earnings, but its potential as a manufacturer of green technologies could still mean that it isn’t as inflated as it first appears.

Its price might see a drastic fall, or it might just prove itself a valuable long-term investment as the world transitions towards renewable energy. Only time will tell.

Nevertheless, if you want to ensure that you don’t fall foul of financial bubbles, one of the best ways to prepare for the risk is by learning from past mistakes.

The specifics might be different, but the fundamentals are the same, and the tulip and railway manias are only two good cases; there are dozens of similar crashes to consider, many of which faced market conditions similar to our own.

Where there are investors, there will be bubbles: that much we know for sure. But by learning from history and avoiding past mistakes, you can ensure you’re in the clear when the enthusiasm fades and they inevitably burst.