You must have certainly come across this instance – When you visit a doctor to get an ailment treated, sometimes it is just him reassuring us that makes us feel better and triggers our internal healing process. Many times, it is the trust in a prescription that cures a person rather than the pill itself. We call this ‘The Placebo Effect’. However, not all times an induced response is positive. In some cases, it may even harm the entity involved. That is ‘The Nocebo Effect.’
These effects are based on the findings of the Russian Scientist Ivan Pavlov who conducted an experiment on dogs and found that a stimulus quite unrelated to food made the dogs salivate. In an experiment, he rang a bell just before giving food to a dog. He repeated this several times until the dog salivated merely at the sound of the bell despite no sight or smell of food being present. The sound of the bell alone produced a response as the food did. The dog learned to associate the bell with food. Thus, these effects are driven by classical conditioning and expectation.
This instinct can also serve as an effective tool for manipulation. For example, in Robert Cialdini’s popular work ‘Influence- Psychology of Persuasion,’ he talks about a friend who had trouble selling turquoise jewelry despite trying several marketing tactics and gimmicks. One fine day, he mistakenly alters the price tags, marking the jewelry at double the prize. And to his amazement, the entire range got sold out that day itself.
You have all the right to wonder ‘why’? Well, the reason for such behavior was that customers with little to no knowledge of turquoise were conditioned to associate high price with high value. We, as humans, are behaviourally biased to ‘extremize’ the unknown and to justify this emotion with the reasoning that ‘price equals value (quality)’. This is not always true. It is this bias that casinos, NFTs and Crypto Exchanges have been using to their benefit. The higher the price for a coin or ‘JPEG’, the more it is speculated on, which in turn drives its value higher, until one day its value depreciates to nothingness. This has been a common trend for a lot of shitcoins and NFTs.
Consumer-based companies tend to use this mental conditioning to their advantage. They flood the markets with discounts, coupons and vouchers and entice people to buy items impulsively and irrationally. Quite akin to the bell ringing for the dog. Fast fashion owes a lot to Placebo. This problem becomes more pronounced in countries like India, where the mimetic behavior (demonstration effect) is quite powerful.
Thanks to everything getting smarter – from smartwatches, smartphones to even smart shoes, consumers have access to huge amounts of health-related data. While data helps us make better decisions concerning our lifestyle, an influx of information may end up making us overanxious. This is what the Paradox of Information ideates and is a classic example of nocebo playing out. The Paradox of Choice states that the more choices we have, the lesser is our confidence to transact.
Investors, being humans, also suffer from this powerful conditioning that leads them into making wrong decisions. The Placebo effect in Investment decisions is real. The action bias combined with the Placebo Effect makes investors feel good after investing because their brain conditions them into believing they have performed an important action. This is also why a majority of the investing public are drawn towards active trading as it entails a feeling of action. This is even though many active fund managers are unable to consistently beat even the index. Also, a great number of people act on borrowed convictions and cues rather than studying what is right for them in a particular situation.
Most investors tend to act on indices as a true representative of the health of the economy and base their overall decision to invest on the same. For example: – when the Sensex falls heavily (akin to Pavlov ringing the bell), it triggers a conditioned response (panic or fear akin to salivation) in investors, and without even investigating the business fundamentals of the stocks in their portfolio they start shorting it. There could be stocks of certain companies which are ‘Antifragile’ and perform well in times of crisis. For example- API manufacturers during the Covid sell-off. These companies present excellent opportunities to generate alpha.
When in markets, significant alpha can be generated only by being counterintuitive. It is only in this territory that multi-baggers can be created. Markets reward an investor for spotting the winners well before the market gives it the value it commands. Otherwise, markets are extremely efficient.
Most traders act on triggers guided by their hindsight bias. They base their decisions on past events and have little idea what they are about to go through. Thus, acting blindly like a Pavlovian dog, they place complete faith on pre-set indicators that can lead them astray. By this, I do not mean to eliminate rule-based trading. Setting certain principles for oneself while trading helps overcome certain powerful behavioral biases. But one should not be rigid about them. Though pattern recognition is important, it is important to acknowledge the limits of our assessment. Around 99% of traders are unable to beat the average F.D. returns. This presents an obvious reason why markets would always be more overpowering and often go undetected by our analytical abilities.
Thus, we see both Placebo and Nocebo playing out in different circumstances. Awareness about such classical conditioning can be very useful for creating good habits or breaking bad habits. Once you can identify the cue which triggers the associated conditioned response, you can easily break the routine and replace the bad habit with a good one. Useful as a human, as a consumer and as an investor.