Congratulations Bitcoin millionaires. You made your first and perhaps your second million of dollars — quickly, very quickly. Perhaps in the last six months in the Bitcoin investment trust. Now make sure that you don’t lose all that money faster than you made it, and then some.
Like Sir Isaac Newton back in 1720s who amassed a great fortune by buying shares early on in South Sea Company — and then lost it all and much more.
Newton’s mistake was that he didn’t resist a common temptation during bubble markets: getting back into a bubble asset at higher price, and staying with it as market sentiment changes and the bubble bursts.
“Back in 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England,” writes Jason Zweig in the commentary for the revised edition of Benjamin Graham’s The Intelligent Investor. “Sensing the market was getting out of hand, the great physicist muttered that he “could calculate the motions of heavenly bodies, but not the madness of the people.” Newton dumped his South Sea Company shares, pocketing a 100% profit totaling 7,000 pounds.
But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in… at a much higher price — and lost 20,000 pounds (or more than $3 million in today’s money).
For the rest of his life, he forbade anyone to speak the words “South Sea Company” in his presence.”
Behavioral finance experts have a good explanation for this kind of behavior. It is called mental accounting, which —unlike traditional accounting— causes individuals to treat gains in financial markets, lottery winnings and other bets differently from money earned from labor, interest income or other sources.
How? By assuming higher risks.
That’s often the case with money won in a casino.
As Richard H. Thaler and Cass R. Sunstein explain in Nudge, “you can see mental accounting in a casino. Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it in one pocket, and put the money he brought with him to gamble that evening (yet another mental account) into a different pocket. Gamblers even have a term for this. The money that recently has been won is called ‘house money’ because in gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as ‘gambling with the house’s money’ — as if it were somehow different from some other kind of money. Experimental evidence suggests that people are more willing to gamble with money they consider house money—like buying into an inflated asset.
Still, Newton’s example suggests that committing this costly mistake has nothing to do with intelligence, and everything to do with emotions — like greed — which lead investors to costly mistakes.