From Tulip Mania to Today: The Perils of Unsophisticated Investors

Written By Luke Burgess

Posted June 7, 2023

I hope this doesn’t come off as arrogant or smug, but when we look back at historical market crashes, one thing becomes clear: The presence of unsophisticated investors has been a recurring factor.

What do I mean by “unsophisticated investors”?

Well, these are simply individuals with limited market experience and lower net worth. And, again, I don’t mean to sound pompous, but unsophisticated investors can have a significant impact on market volatility and contribute to major market crashes.

Now, of course, market crashes ultimately result from a combination of complex macroeconomic factors. Unsophisticated investors are not the only cause of market crashes but they are certainly a major contributing factor.

Their lack of knowledge and understanding of market dynamics can lead to impulsive decision-making and contribute to irrational behavior during times of market turbulence. This behavior can create a domino effect, amplifying market volatility as a result of sudden buying or selling pressure. 

The collective actions of unsophisticated investors can distort market prices and exacerbate fluctuations, potentially leading to a loss of confidence and triggering a broader market crash.

We've seen this as a pattern in events like the Tulip Mania of the 17th century and the market crash of 1929, where an influx of inexperienced participants contributed to excessive speculation and subsequent crashes.

During Tulip Mania, people began buying tulips with leverage, using margined derivatives contracts to buy more than they could afford. This allowed everyone to become involved in the trade.

The Library of Economics and Liberty writes, “The rage among the Dutch to possess [tulip bulbs] was so great that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade.”

Beth Daley of The Conversation comments, “No one wanted the bulbs, only the profits — it was a phenomenon of pure greed. Tulips were sold for crazy prices — the price of houses — and fortunes were won and lost. It was the foolishness of newcomers to the market that set off the crash in February 1637.” 

Similarly, the market crash of 1929 can also be partially attributed to the actions of unsophisticated investors. During that time, margin buying also played a significant role in exacerbating the crash, as leveraged investments amplified losses and magnified market fluctuations.

It is crucial to emphasize that unsophisticated investors are not the sole cause of market crashes. A multitude of macroeconomic factors are at play. However, these investors' collective actions can distort market prices, intensify volatility, and contribute to a loss of confidence, potentially triggering broader market crashes.

And in recent years, equity markets have seen a massive increase in the number of unsophisticated investors, particularly in the cryptocurrency, NFT, and tech markets.

Two key developments have played a significant role in this trend.

The first is online and mobile trading. Web-based trading is something we all take for granted these days, but it really wasn't that long ago that buying and selling stocks involved much more effort.

Buying stocks before the internet involved actually calling a broker who would manually execute the trade on your behalf. Moreover, doing research on a company pre-internet involved calling the company or visiting a library. There’s no doubt the internet brought people into the equity markets who wouldn’t be there without it.

The second development is more recent: fractional share trading

Fractional share trading allows individuals to purchase fractional portions of expensive stocks that were previously out of reach. Proponents say it democratizes investing by allowing individuals to buy fractional portions of expensive stocks that were once out of reach. This inclusivity is commendable, but it also means that the impact of unsophisticated investors on market dynamics could be amplified.

To mitigate the potential risks associated with unsophisticated investors, it is essential for market participants and regulators to focus on education, guidance, and protection measures. By acknowledging and addressing the challenges posed by unsophisticated investors, we can work toward a more informed and sustainable market ecosystem.