Finance and Insurance - The Profit Center I would like to make myself clear on a few items of interest before I get too deep into the sales processes at any dealership, including: automobile, recreational vehicles, boats, motorcycle, and even furniture or other big ticket items. A business has to turn a fair profit in order to stay in business. I believe that they should make this profit and use it to pay better quality employees a premium wage in order to serve you better. The financial strengths or weaknesses of any business can definitely have a dramatic effect on your customer service and satisfaction. I do not, in any shape or form, wish to hurt a dealerships profitability, as it is essential for his survival. I merely want to advise people how to negotiate a little better in order to make the profit center more balanced. Let's get right down to this! Every dealership has a finance and insurance department. This department is a huge profit center in any dealership. In some cases, it earns more money than the sale of the automobile itself. Profits are made from many things that most buyers do not understand. You as a consumer should understand the "flow" of the sales process to understand the profit centers that are ahead of you. Most negotiating from the consumer seems to stop after the original price is negotiated and agreed upon. Let's examine just a small portion of what leads up to that point. The first thing that every consumer should understand is that when you go to a dealership several things come into play. One of the most important things that I could point out to you is that you are dealing with a business that has been trained to get the most amount of money from you as they can. They are trained and they practice these tactics everyday, day after day, week after week, month after month, and year after year. Let me point out a couple of important facts that I have said in this paragraph. First, you'll notice that I said a dealership and not a salesman and secondly, I emphasized times of day after day, week after week, etc. etc. This was done to let you know that the salesman is working very closely with the sales managers in order to make as much money as he can. Your interests are really not their objective in most cases. One tactic that is used heavily in the business is that the salesman says he is new to the business. This may be true or not, however; keep in mind that he does not work alone. He is working with store management, who gives him advice on what to say and when to say it. These guys or gals are very well trained on how to overcome every objection that you may have to buying from them. They have been trained in the psychology of the buyer and how to tell what your "hot buttons" are. They listen to things in your conversation that you may say to one another as well as to the salesman. They are trained to tell their desk managers everything that you say and then the desk manager is trained to tell the salesman exactly what and how to answer you. A seasoned salesman does not need as much advice from his desk and may negotiate a little more with you directly without going back and forth. The process of negotiation begins the moment that you walk into the front door or step foot out of your car and begin to look at vehicles. Different stores display inventory in different ways. This is done for crowd control or more commonly known as "up control". Control is the first step in negotiating with a customer. Ever who asks the questions controls the situation. Let me give you an example: A salesman walks up to you and says "Welcome to ABC motors, my name is Joe, and what is yours?" The salesman has just asked the first question- you answer "My name is George." He then asks you what you are looking for today, or; the famous "Can I help You?" As you can see, step after step, question after question, he leads you down a path that he is trained to do. Many times a well trained salesperson will not answer your questions directly. In some cases, they only respond to questions with other questions in order to avert the loss of control. An example of this could be something like you asking the salesman if he has this same car with an automatic rather than a stick shift. Two responses could come back to you. One would be yes or no, the other could very well be something along the lines of: 'don't you know how to drive a stick shift?" In the second response the salesman gained more information from you in order to close you. Closing means to overcome every objection and give your customer no way out other than where do I sign. The art of selling truly is a science of well scripted roll playing and rehearsal. We have established that the negotiating process begins with a series of questions. These questions serve as two main elements of the sales process. First and foremost is to establish rapport and control. The more information that you are willing to share with you salesman in the first few minutes gives him a greater control of the sales process. He has gathered mental notes on our ability to purchase such as whether you have a trade in or not, if you have a down payment, how much can you afford, are you the only decision maker (is there a spouse?), how is your credit, or do you have a payoff on your trade in? These are one of many pieces of information that they collect immediately. Secondly, this information is used to begin a conversation with store management about who the salesman is with, what are they looking for, and what is their ability to purchase. Generally, a sales manager then directs the sales process from his seat in the "tower". A seat that generally overlooks the sales floor or the sales lot. He is kind of like a conductor of an orchestra, seeing all, and hearing all. I cannot describe the entire sales process with you as this varies from dealer to dealer, however; the basic principals of the sale do not vary too much. Most dealerships get started after a demo or test drive. Usually a salesman gets a sheet of paper out that is called a four square. The four square is normally used to find the customer's "hot points". The four corners of the sheet have the following items addressed, not necessarily in this order. Number one is sales price, number two is trade value, number three is down payment, and number four is monthly payments. The idea here is to reduce three out of the four items and focus on YOUR hot button. Every person settles in on something different. The idea for the salesman is to get you to focus and commit to one or two of the hot buttons without even addressing the other two or three items. When you do settle in on one of the items on the four square, the process of closing you becomes much easier. One thing to keep in mind is that all four items are usually negotiable and are usually submitted to you the first time in a manner as to maximize the profit that the dealer earns on the deal. Usually the MSRP is listed unless there is a sales price that is advertised (in may cases the vehicle is advertised, but; you are not aware). The trade value is usually first submitted to you as wholesale value. Most dealers request 25-33% down payment. Most monthly payments are inflated using maximum rate. What this all boils down to is that the price is usually always negotiable, the trade in is definitely negotiable, the down payment may be what you choose, and the monthly payment and interest rates are most certainly negotiable. If you do your homework prior to a dealership visit you can go into the negotiation process better armed. You still need to keep two things in mind through this process. The first item is that you are dealing with a sales TEAM that is usually highly skilled and money motivated. The more you pay the more they earn. The second item to remember is that you may have done your homework and think that you are getting a great deal and the dealer is still making a lot of money. The latter part of this statement goes back to the fact that it is essential for a dealer to make a "fair" profit in order to serve you better. Once your negotiations are somewhat settled, you are then taken to the business or finance department to finalize your paperwork. Keep in mind that this too is another negotiating process. In fact, the finance manager is usually one of the top trained sales associates that definitely knows all the ins and outs of maximizing the dealerships profit. It is in the finance department that many dealers actually earn more than they earned by selling the car, boat, RV, or other large ticket item to you. We will break these profit centers down for you and enlighten you as to how the process usually works. Remember that finance people are more often than not a superior skilled negotiator that is still representing the dealership. It may seem that he or she has your best interests at heart, but; they are still profit centered. The real problem with finance departments are that the average consumer has just put his or her guard down. They have just negotiated hard for what is assumed to be a good deal. They have taken this deal at full faced value and assume that all negotiations are done. The average consumer doesn't even have an understanding of finances or how the finance department functions. The average consumer nearly "lays down" for anything that the finance manager says. The interest rate is one of the largest profit centers in the finance department. For example, the dealership buys the interest rate from the bank the same way that he buys the car from the manufacturer. He may only have to pay 6% to the bank for a $25,000 loan. He can then charge you 8% for that same $25,000. The dealer is paid on the difference. If this is a five year loan that amount could very well be $2,000. So the dealer makes an additional $2,000 profit on the sale when the bank funds the loan. This is called a rate spread or "reserves". In mortgages, this is disclosed at time of closing on the HUD-1 statement as Yield Spread Premium. This may also be disclosed on the Good Faith Estimate or GFE. You can see why it becomes important to understand bank rates and financing. Many finance managers use a menu to sell aftermarket products to you. This process is very similar to the four square process that I discussed in the beginning. There are usually items like gap insurance, extended service contracts, paint and fabric guard, as well as many other after market products available from this dealer. The menu again is usually stacked up to be presented to the consumer in a way that the dealer maximizes his profitability if you take the best plan available. The presentation is usually given in a manner in which the dealer wins no matter what options are chosen. With the additional items being pitched to you at closing, your mind becomes less entrenched on the rates and terms and your focus then turns to the after market products. Each aftermarket item can very well make the dealer up to 300-400% over what he pays for these items. Gap coverage for example may cost the dealer $195.00 and is sold to the consumer for $895.00. The $700.00 is pure profit to the dealer and is very rarely negotiated down during this process. The service contract may only cost a dealer $650.00 and is being sold for $2000.00. The difference in these items are pure profit to the dealer. You see, if you only paid $995.00 for the same contract, the dealer still earns $345.00 profit from you and you still have the same coverage that you would have had if you had paid the $2000.00. The same is true for the gap coverage. You are covered the same if you paid $395.00 or $895.00 if the dealers costs are only $195.00. The only difference is the amount of profit that you paid to the dealer. Another huge profit center is paint and fabric protector. In most cases the costs to apply the product are minimal (around $125.00 on average). In many cases the dealer charges you $1200-$1800 for this paint and fabric guard. As you can see, these products sold in the finance department are huge profit centers and are negotiable. I also have to recommend the value of most all products sold in a finance department. It is in your best interest to get the best coverage possible at the best price possible. Always remember this: The dealer has to make a fair profit to stay in business. It just doesn't have to be all out of your pocket.
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Behavioural Finance: Focus on Intrinsic Value INTRODUCTION The volume of research in the field of Behavioural Finance has grown over the recent years. The field merges the concepts of finance, economics and psychology to understand the human behaviour in the financial markets, to form winning investment strategies. THE CONCEPT OF BEHAVIOURAL FINANCE Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Principal objective of an investment is to make money. We usually assume that investors always act in a manner that maximizes their return rationally. The Efficient Market Hypothesis (EMH), the central proposition of finance for the last thirty five years rests on assumption of rationality. But it has been proved that people are ruled as much by emotion as by cold logic and selfishness. While the emotions such as fear and greed often play an important role in poor decisions, there are other causes like cognitive biases, heuristics (shortcuts) that take investors to incorrectly analyse new information about a stock or currency and thus overreact or under react. Behavioural Finance is the study of how these mental errors and emotions can cause stocks or currency to be overvalued or undervalued, and to create investment strategies that gives a winning edge over the others investors. I would like to bring out the behaviour pattern of a rational investor. This rational investor is assumed to act rationally in following ways: o Makes decisions to maximize the expected utility. o Fully informed with unbiased information. o Absence of any distortion of judgement based on emotions. It is to be kept in mind that risk resides not only in the price movements of dollars, gold, oil, commodities, companies and bonds. It also lurks inside us - in the way we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings. Information is useless if we misinterpret it or let emotions sway our judgement. Human beings are irrational about investing. Correct behaviour patterns are absolutely essential to successful investing - so to be financially successful one has to overcome these tendencies. if we can recognise these destructive urges, we can avoid them. Behavioural Finance combines the disciplines of economics and psychology specifically to study this phenomenon. THE CONCEPT OF BUBBLES IN STOCK MARKET A speculative bubble occurs when actions by market participants' results in stock prices to deviate from their fundamental valuation over a prolonged period of time. Speculative bubbles are difficult to explain by rational trading behaviour, and theories have been put forward to explain market psychology through behavioural finance1. They propose that when significant proportion of trading activity in the market is characterized by positive feedback behaviour, it may result in asset prices to shift away from their fundamental valuation. This price deviation encourages rational investors to trade in the same direction. Speculative trades are based upon investors' private information held today, and are designed to provide investors with higher returns in the next period when that private information is fully revealed to the market. This implies a positive correlation in returns as market incorporate the information into prices. Trades due to portfolio rebalancing, or hedging, is not information based, and occurs when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his stock holding. This will be accomplished by increasing (or decreasing) the stock price to induce the opposite side of the trade. FOCUS ON INTRINSIC VALUE What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations: o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value. o Repurchasing shares when the market under-prices them relative to their intrinsic value. o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value. Two things must be kept in mind as regards this aspect of market deviations. Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value. Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions. It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value. INVESTING IRRATIONALITIES Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves : Herding This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality: o Panic buying o Panic selling Holding Out for a rare treat Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss. If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems. ISSUES One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not. The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time. So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complexity of information received. Psychological research has shown that the human brain often uses shortcuts to solve complex problems. These heuristics are rules or strategies for information processing, which help to find a quick, but not necessary optimal, solution. Once the information is simplified to manageable level, people use judgement heuristics. These shortcuts are needed to resolve the decision making as quickly as possible. Heuristics are also used to arrive at a quick judgement, they can, however, also systematically distort judgement in certain situations. SIMPLIFICATION BIAS The first step in reducing complexity is to simplify the decision. However it also adds the risk of arriving at a non-rational conclusion, unless one is careful. MENTAL ACCOUNTING People focus on one account (say purchase of share x) in particular when weighing things, relationship with other commitments or accounts (say purchase of share y) are usually ignored. I would like to explain this with the help of an illustration. For instance, Company A produces bathing costumes, and company B produces raincoats. Both companies are new, extremely efficient and innovating, so that purchasing shares in these companies would be a profitable proposition. A financial gain, however depends to a large extent on the whether in both cases, Company A will produce huge profits if the weather is fine, while Company B will make a loss, even though this is kept to a minimum, thanks to its efficient management. The situation is reversed in the case of bad weather. With mental accounting, either investment is risky when seen in isolation. But if we take into account the mutual effect of the uncertainty factor, i.e. the weather, then a combination of both shares become a lucrative, and at the same time secure investment. AVAILABILITY CONSTRAINT Not everybody has same degree of information. Some people prefer to see business news on CNBC TV 18, NDTV PROFIT. But others may like to see the serials on STAR PLUS. Obviously the first one may have more information, as compared to second. REPRESENTATIVENESS This is one of the mental shortcuts that make it hard for investors to correctly analyse new information. It helps the brain organise and quickly process large stock of data, but can cause investors to overreact to old information. For example, if a company is repeatedly giving losses, investors will become disillusioned with this past data, and thus may overreact to past information by ignoring valid signs of recovery. Thus, the stock of the company is undervalued because of this bias. CHLALLENGES Under the paradigm of traditional financial economics, decision makers are considered to be rational and utility maximizing. The assumption of rational expectations is simply an assumption - an assumption that could turn out not to be true. Behavioural Finance has the potential to be a valuable supplement to the traditional financial theories in making investment decisions. The following fundamentals of behavioural finance give us a glimpse of the pitfalls to be avoided. These are the challenges which need to be overcome and addressed. 1. Hubris hypothesis: it is the tendency to be over optimistic. It results from psychological biases. The investor gets swayed by the momentum generated in the markets in recent past. 2. Sheep theory: it is a phenomenon where all the investors are running in the same direction. They follow the herd - not voluntarily, but to avoid being trampled. 3. Loss aversion: it says that investors take more risk when threatened with a loss. Thus mental penalty associated with a given loss is greater than the mental reward from a gain of the same size. 4. Anchoring: this causes investors to under react to new information. This can lead to investors to expect a company's earning to be in line with historical trends, leading to possible under reaction to trend changes. 5. Framing: this states that the way people behave depends on their way decision problems are framed. Even the same problem framed in different ways can cause people to make different choices. 6. Overconfidence: this is what leads people to think that they know more than they do. It leads investors to overestimate their predictive skills and believe they can time the market. RELEVANCE TO INDIAN STOCK MARKETS Behavioural finance holds definite clues and appears apt in the current IPO craze as regards Indian markets are concerned. The herd mentality is evident in the scramble for shares. As the positive information of excess subscriptions comes, more investors enter the bandwagon. When Prices of the stocks start soaring, everyone one is thinking of the same thing: I am going to sell on listing and book the profits. Can money making be so simple? Is life and the financial markets so predictable? One will see investors selling the stocks as soon as they get the allotments. Herd mentality will be at work with people trying to sell faster than the neighbour, thus eroding stock values at a faster rate. Greed thus becomes the graveyard. One needs to understand that there are no shortcuts to earning money. One has to work hard and have patience. It is believed that perfect application of Behavioural finance can make an Indian investor successful, making fewer mistakes. Even if we learn to identify some common psychological and cognitive errors that plague even the wisest investment professional, it may be enough. To put it in Simple words, economic theory starts with a flawed basic premise that the investor is a rational being who will always act to maximise his financial gain. Yet, we are not rational beings, we are human beings. In stock markets, behavioural finance can help explain situations such as why we hold on to stocks that are crashing, foolishly sell stocks that are rising, ridiculously overvalue stocks, jump in late and never find our right price to buy and sell stocks. Let's take the example of the recent discovery of gas by Reliance industries. The stock starts spurting as everyone starts buying on this news. Newspapers start flashing stories as to the size of such a discovery. But let us analyse the situation without becoming a prey to mental heuristics. Gas has been discovered but the same needs to be drilled which takes a lot of time and money. What is the quality of the gas? How many wells would be needed for drilling? How much time will it take? How much money would be required and what are the plans to finance the same? How easy it is going to be to extract the same? These are all important and pertinent questions. In this time lag there are so many uncertainties the company will have to go through, before the profits are reaped. However, analysts have started predicting the future profitability of Reliance and on such hopes investors start buying the stock at rising prices. This is how mental heuristics work when the brain takes a shortcut in processing information and does not process the full information and its implications. Thus behavioural finance has a pivotal role to play in Indian Capital market. CONCLUSION Knowing the heuristics shall help the investors to which they are susceptible and this will help them in neutralizing to some extent the distortions in the perception and assimilation of information. This will in turn, help the investor to take a rational decision and get a cutting edge over the other not-so-rational investors. More research on behavioural finance should take place not only in asset pricing but also in areas like project appraisal & investment decisions and other areas of corporate finance, so that managers can avoid the decision traps. Psychology and irrational behaviour matter on financial markets. Behavioural finance is relevant in many ways. It educates investors about how to avoid biases, designing long and short term strategies to exploit biases; and being aware that decision-makers in financial markets are human beings with biases. We also need to realize that an implicit assumption of behavioural finance is that their findings at individual level are scalable to market level. Mr. Amarendra B. Dhiraj is a frequent speaker at internationally renowned global events, CEO/CTO/CIO Roundtables, Technology Conferences and Symposiums. He hosted and organized the Executive Technology Leadership Forum. He specializes in strategy, innovation, and leadership for change. His strategic and practical insights have guided leaders of large and small organizations worldwide.




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