You purchase a brand new mobile for Rs. 10000. The first year you have a free warranty. The salesman offers you a warranty for the second year for Rs. 500. You fall for the bait and buy the second year warranty. What are the chances of your mobile conking off in the second year. May be 1% looking at the track record of all the mobile phones in the last few years. So your warranty is worth only Rs.100. However you believe that the salesman is your best advisor and pay Rs.500 for something which is worth only Rs.100.
However you are in an efficient market and competition will ensure that market forces will drive out these warranties from the market or the warranty prices come down to Rs.100 as more companies start giving warranties. This is how a rational mind will think. Well you are dead wrong if you assume the above to happen.Warranty is a product no one should buy. If humans realized that they would be paying Rs.500 for Rs.100 worth of insurance, they would not buy the insurance. But if they do not realize this, markets cannot and will not reveal the situation.
Competition will not bring the prices down. The salesman plays an important role as a friend and an advisor to sell you something worth Rs.100 for Rs.500. It is difficult for third parties to enter the market efficiently as how can they make money by persuading you not to buy.
When many people are still afraid of flying it was common to see airline flight insurance sold at airports at exorbitant prices. There were no booths on airports selling people advice not to buy such insurance.
Now when the stock markets are up one must be careful. You have brokers, investment bankers, mutual funds, banks in the guise of your best friends and advisers trying to sell you dreams. When the markets are up more mutual funds and more IPO’s hit the markets. They want to benefit from irrational behavior of investors. However there will be no firms asking you not to be swayed as they cannot benefit from it.
We are in a market where firms compete for the same consumers. Some sell cigarettes and some help you to quit smoking. Some sell fast food while others advise you for diet. If all are rational human beings (econs) then there is no argument which competing interest will win. However the problem is that consumers are humans and make irrational decisions leading to bad choices. Here is how firms benefit out of their irrational behavior. In stock markets we have opposing interests like day traders v/s long term investors and stock tips v/s value investors. Irrational investors add to the chaos making it easy for firms to benefit from their irrationality. Your business news channel has become your stock advisor, the banks salesman is your financial advisor,and your friendly neighbor is your portfolio manager.
At present stock markets are going through great volatility. It is important that investors keep their cool and behave rationally. There are hawks waiting to make money out of you. Remember there are no short cuts in life. Ponder on the following questions: Why do IPO’s not come in bear markets? Why do we not get stocks tips daily on our mobile in bear markets? Why don’t FIIs buy in bear markets when the prices are low? Why do experts predict markets higher when the stocks are going up? How does one know that the Sensex will touch 25000?
My friend you are in a bull market. You are more likely to turn irrational and make big money mistakes. That’s the reason you got to be cool and not be carried away by the noise of the markets.