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Isaac Newton’s groupthink folly: focusing on froth, not performance.

July 2022

Key Points

  • The 18th-century mathematician Sir Isaac Newton lost a fortune in the South Sea Company stock market bubble
  • His misfortune highlights the investing risk of being swept up by sentiment rather than focusing on business fundamentals
  • Speculators’ misbelief that they can predict short-term market swings underlines the importance of our patient, long-term investment approach
© National Portrait Gallery/Alamy Stock Photo

Please remember that the value of the investment can fall and you may not get back the amount you invested. Past performance is not a guide to future returns.

Whenever large stock price swings occur, there is a temptation to ignore the fundamentals and let groupthink override your judgement.

Even Sir Isaac Newton – the renowned physicist, mathematician and Master of the Royal Mint – fell victim to a period of such exuberance just over 300 years ago.

Sir Isaac acquired shares in the South Sea Company shortly after its launch in 1711, as documented by the Royal Society. The British firm had been created to sell enslaved Africans to the Spanish Empire to mine gold and silver in its Central and Southern American colonies.

The trade is distasteful but was legal at the time. However, it failed to deliver the level of expected profits. In 1720, the company switched focus to deal in the UK national debt, using the cash generated by additional share sales to meet interest payments.

In doing so, it created a stock market bubble. Its shares and others’ soared in value thanks to a mixture of hype and greed.

Sir Isaac had the sense to sell his South Sea Company shares for a significant profit in the first half of 1720. Historians believe he had become fearful of market froth.

But then the 77-year-old saw the stock continue to climb, and he bought back in at about double the price. That was close to the stock’s peak when the firm’s value totalled twice that of all land in England.

Soon after, the stock collapsed, crashing the wider market.

After his death, it was reported that Sir Isaac had lost £20,000 in the market panic. That’s more than £3m in today’s money.

He was quoted, perhaps inaccurately, as having said on the matter: “I can calculate the motion of heavenly bodies, but not the madness of people.”


Focusing on fundamentals

The affair reminds us of the difference between being an ‘investor’ and a ‘speculator’.

Investors view their share certificates as giving them part-ownership of a business in which they are effectively a silent partner.

Speculators, by contrast, see stock ownership as a way to second guess the market.

The distinction between the two is clearest in times of market flux.

Speculators take direction from share price swings, giving little care to underlying businesses and their fundamentals.

In contrast, we fit into the investors’ camp. We focus on acquiring and holding shares at suitable prices rather than market timing. And our response to significant market shifts – in either direction – is to revisit the fundamentals. We endeavour to buy and hold only if we believe a company’s future growth will deliver a significant return via dividend payments and a higher share price over the long term. And we sell back to the market when that is no longer true.

So a share price move might trigger a review, but in isolation it typically provides little insight into the underlying opportunity.


Interest rates

A case in point is the recent change in sentiment about internet-related growth stocks trading at relatively high price-to-earnings ratios.

Earlier this year, many market participants sold en masse after taking their cue from others. They shunned anything internet-related, assuming interest rate rises would reduce future cash flows and make funding more difficult.

By contrast, we believe that an inflationary environment could increase demand for the products and services of our internet-related holdings as offline alternatives become sparse and more expensive.

In addition, many of Japan’s online businesses benefit from cash-rich coffers and healthy balance sheets. That means they can self-fund their growth.

Rather than take a sector-wide view, we examine the implications of rising inflation and potential rate increases for each of our holdings’ prospects.

That lets us ascertain whether their idiosyncratic characteristics place them in an advantageous position.

This patient approach lets us avoid becoming hostages to fortune, beholden to speculators and the mercurial nature of the market’s mood.

The field of behavioural economics helps explain why people are instinctively driven to read too much into short-term share price swings.

Humans are pattern-seeking animals. We often perceive trends that don’t exist.

Indeed, psychologists have found that when they present volunteers with an unpredictable sequence – for example, a series of coin flips – subjects still insist on trying to infer what comes next.

The Nobel Prize-winning psychologist Daniel Kahneman and his late colleague Amos Tversky did groundbreaking work on how we make decisions at times of uncertainty.

They found that we often lose all sense of context and proportion when facing a loss. And they suggested the pain of a financial failure is twice as intense as the pleasure of an equivalent gain.

Their work indicates that people tend to become more irrational when faced with market falls because they try to mitigate the fear of further losses.

So arguably two prerequisites of successful investing are thinking in longer time frames and maintaining mental toughness.


Performance and growth

We expect share prices to fluctuate and will never buy a stock just because it has gone up, nor sell one just because it has gone down.

Sir Isaac Newton may have learned this lesson the hard way.

But investors should pay heed to another of his quotes: “Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things.”

With that in mind, we focus on our holdings’ performance rather than post hoc explanations for share price moves.

We can see that some of our portfolio companies’ operating profits were recently at all-time highs. Moreover, several of our weakest share-price performers have posted strong – and in some cases accelerated – rates of top-line growth.

This may well present us with extraordinary opportunities to add to positions and generate significant upside for clients.

Find out more about the Japanese Income Growth Fund,
or for more detail view the Japanese Income Growth Fund Factsheet.

Risks and Important Information

Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the fund, and any income from it, can fall as well as rise and investors may not get back the amount invested. The Japanese Income Growth Fund’s exposure to a single market and currency may increase share price movements. The fund’s share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the fund is priced.

The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research.

Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions.

Baillie Gifford & Co Limited is wholly owned by Baillie Gifford & Co. Both companies are authorised and regulated by the Financial Conduct Authority and are based at: Calton Square, 1 Greenside Row, Edinburgh EH1 3AN. Baillie Gifford & Co Limited is the OEICs’ Authorised Corporate Director.

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