Question

Mr. Wolf calls you with what he says is a tremendous opportunity in the stock market. He has inside knowledge about a pharmaceutical company and he says that the price will go up tomorrow. Of course, you are skeptical and decline his offer. The next day the price does go up. Mr. Wolf calls again and says not to worry, tomorrow the price will go down again and that will be a good time to buy. Again, you decline. Mr. Wolf calls you over the next several weeks and every time he calls his predictions about the stock price prove to be amazingly accurate. Finally, he calls to tell you that tomorrow is the big one, the day the price will skyrocket. Mr. Wolf has been accurate many times in a row so you empty your bank account to buy as much stock as possible. The next day the price of the stock goes nowhere. What happened?

Answer 1

Mr Wolf acted just like his name.He had manipulated the investor to buy stocks.Perhaps he might have been working with the said pharmaceutical company to create positive expectations about the stocks and raise its prices or he himself had brought lots of these stocks which he wanted to sell once a buying comes up in the market.He duped the investor by constantly luring him and locking the investor's deposits in a stock whose prices may or may not fetch expected prices.It may so happen that the prices would continuously fall and erode the prices of the entire stocks over time.(It is assumed that given the way Mr Wolf had acted all this while there is a negligible possibility that this time he had genuinely miscalculated the market.)

Mr Wolf knows that there are always a 'kind' of investors who are gullible. They have various short term and long term goals and not sufficient salary to fulfill them.These investors without having complete knowledge of market in which they are investing rely on past performance indicators.Such indicators are nothing but plots to build a 'trust' factor.Here Mr wolf constantly told the investor about his predictions which surprisingly came 'true'.The investor did not believe them at first but later with advent of time realized that he is loosing out on potential profits/income.So when the investor is told about the big day when prices of stocks will raise to unprecedented levels, the investor was stimulated to the extent that rational behavior was ignored.

Perhaps this was what Mr Wolf wanted- not give them sufficient time to analyse where money is being put in,what risks are involved etc. You would note here that the investor had earlier parked his money in an interest bearing account in bank which is a safe investment.However the same investor became risk loving after believing in Mr Wolf's words and invested an entire lump sum into buying one stock. So Mr Wolf was right this time again- he knew this investor was indeed gullible!

Here the investor should have thought If Mr wolf is right in timing the market every time why is he giving me this information rather than park his own money? Is he acting magnanimous by passing this information.Or is he making use of information asymmetry to his advantage?

Moreover any good investor before buying a stock would say 'Don't put all your eggs in one basket'.If the portfolio is diversified risks are pooled and the value of investments do not fluctuate sharply.