Saturday, April 4, 2015

Pavlovian association bias: We are no smarter than the dogs

Pavlov was a Russian physiologist who conducted an experiment where he sounded a bell at the time a dog ate food. Over time just the sound of the bell caused the dog to salivate. This type of conditioning is called the Pavlovian association bias and can be lethal in investing. This is the bias running in the background that sometimes drives customers to buy the higher value item linking expensive=better quality. The automotive industry has this syndrome played out in wonderful detail. BMW has created a brand for itself where car buyers believe that its quality is better. Several studies have shown that car makers like Honda and Toyota have similar or sometimes even better quality, provide the same features but still consumers continue to buy BMW and it remains one of the most profitable car companies around. Cars like the Rolls Royce or the Bentley have often been proven of poorer quality than several cheaper cars but they continue to sell because of the Pavlovian association bias.

The markets can drive many such classical conditioning biases. Several investors who have been following value investing long enough think that when the markets are falling buying anything will eventually lead to better results – which is simply not true. Momentum trading, (buying stocks that are rising) is another classical conditioning pattern seen in professional traders. Before the dot com boom several people had been conditioned to believe that a technology company always deserves a high multiple. So much so that even a decade after the dot com bust I have heard people saying “it’s a technology company and thus deserves a higher multiple”.

Such biases in investing can cause two mistakes – getting into something you should not have gotten into or missing an opportunity. Avoidance of this bias by the intelligent investor is best done by being aware of such conditioning and reminding yourself that you can have the dog with a bell syndrome. Awareness by itself is a fairly powerful psychological bias removal tool.