Markets know best

It is not hard to come across investment opportunities that seem too good to be true. From the piece of real estate that can never fall in price because it is at a great location to the stock of a company that has great management so it will perennially keep appreciating are all "tips" that one often keeps hearing about. We also hear about the people who made a killing by actually investing in those. In this article, I will talk about when it makes sense to go by these tips and when it does not.

Efficient Markets

This is a technical term that actually is very useful to understand markets. Basically it says that the price of any item (including real estate and stocks) at any time is "correct". By correct it means that if you were to see the movement of price, it would increase in about 50% of the time decrease in 50% of the time. In other words, it is not possible, on an average to make profit.

How does it work?

While the proof and even the interpretation of this statement is very involved, some reflection will convince you that it should be correct. Consider the case of a property that is at a very good location. In this case, it may be the case that the property will be priced higher than others but why would it keep appreciating? On the other hand, if everyone knew it would appreciate than everyone would try to buy it and would make better and better offers to the seller. This would stop only when all the "excess appreciation" was factored into the price. Exactly the same thing works the company with a good product or a good management.

Can one make money out of tips?

A little reflection will tell you that the only way to make money out of tips like this is to get - and act on - them before others do. So your reaction may be to act on them immediately while others are still evaluating. This is often also mentioned in the tip itself. Unfortunately, that is unlikely to help you either.

The reason it does not work is because usually the person giving the tip has no special "love" for you. He could have given the tip to anyone else. Most likely, he chose the order in which to give the tip at random which means that a large number of people must already have received it and much of the price appreciation must already have taken place.

On the other hand, it is a great way to commit fraud. If even some people blindly believe on tips, than prices will increase for a short time. So the person giving those tips can hoard the item in question and sell it when the prices increase. This was the reason a why a couple of years ago promotional SMS about stock tips were banned.

But I believe in this tip

At times you will come across a tip that you think makes sense. Before investing on the basis of it, do ask yourself the following questions - 

1. What new information do I have that others either do not have or do not believe in?
2. Has there been any price movement in the last few days or weeks which may have been due to others getting the above information?
3. What is risk involved? What does it mean for my financial health?

When do markets NOT know the best?

This is one last thing that is important. There are a large number of cases when the market price may be wrong - often for large amounts of time. This often happens when

1. There is a monopoly - a single buyer or a seller.
2. Information is available to a select few - for instance when government comes up with a master plan for a city or a major contract is awarded.
3. Some new technology or innovation comes up - consider the dot com boom and bust
4. The world is going crazy - for instance when the central banks print a lot of money and flood the market with it

But in each of these cases again the only way you can make money is by getting out before everyone else realizes that they made a mistake. On the other hand, the potential to make huge losses is very large. If you realize that such a situation exists, the least that you should do is be very careful.