In the book Predictably Irrational, author Dan Ariely spends a few chapters describing the Placebo effect in medicine. The Placebo effect occurs when an inert substance—like a sugar pill—causes a genuine therapeutic outcome.
For some medical patients, the mere belief that they’re ingesting medicine will cause their brain to enact a genuine physical reaction. Their brain tricks their body into believing the sugar pill was real medicine.
There’s a similar phenomenon in investing.
As investors, our inert actions can yield genuinely positive outcomes in our portfolios. Random decisions, but real gains. It happens all the time.
But if we’re not careful, we could convince ourselves that those inert actions were more than just “sugar pills.” We could falsely think, “Hey – I’m good at this investing thing. All it took was an hour of reading an online forum and I doubled my money…”
So we take even more (still inert) actions, falsely believing that those actions will lead to more good outcomes. Like Dan Ariely would say, it’s predictably irrational. And those positive outcomes might continue. Compounding placebos, compounding good luck, compounding returns.
But since the underlying actions are nothing more than placebos, repeatable results aren’t guaranteed. Eventually, the law of large numbers will frown upon these investors. Their results will revert to the mean. And their house of cards will crumble.
Examples of Investing Placebos
What are some examples of these “investing placebos?”
Timing the market – Predicting market tops and bottoms is famously difficult. If you ‘time the market‘ correctly once, you might think you’ve found your personal billion-dollar secret sauce. A few more such correct predictions and you’ll be rich. But a list of historical “one-hit wonder” market timers would disagree with you.
Picking individual stocks on little research – More than any example on this list, picking individual stocks (that happen to become winners) is the most common placebo I hear when talking to everyday investors.
They’ll offer stories like, “I heard about Tesla in 2015 and did some research over a long weekend. That convinced me to buy, and I’ve held it ever since. And now my investment is 30x higher.”
It’s a great story. And congrats on the 30x winner. But Average Joe’s “weekend of research” is a sugar pill compared to the rigor of real investment research.
Investing based on macro-economic ideas – This placebo might present itself as, “I read that America’s gross domestic product was going to rise 3% this year, so I bought stock in a train company. Higher GDP, more stuff, more transportation needed—trains should do well. And sure enough—the stock rose!”
This kind of prediction completely neglects that the stock represents ownership of a business. That business has costs. It has labor and management. It has competitors! A business is so much more complex than, “How will the economy behave this year?”
Making investment choices based on macroeconomic trends is notoriously irrational behavior.
Chasing past results: Here’s another common one, especially among inexperienced investors. Quite logically, they think, “Since this fund returned 20% per year for the past 5 years, it should continue to do so in the future.”
Unfortunately, this logic is wrong. Study after study proves that fund persistence is largely a myth.
So if you happen to pick a fund that did well in the past and does well for you in the present, congratulations! You found a helpful placebo. Recognize it for what it is, and count your blessings.
“Ducks in the rain” – Investing legend Warren Buffett loves to point out how some investors act like “ducks floating on a pond in a rainstorm. They think they’re rising in the world. But it’s all just the rain.”
A bull market acts as that rain, and many investors are fooled into thinking they’re “rising in the world” via their investment wisdom. Nope. It’s just the bull market pushing them upward.
All Out of Pills…
Speaking of rain…sometimes, a rain dance will actually precede a storm. And some of our ancestors were predictably irrational in believing that their dances caused that rain.
Don’t forget: those “superstitious” ancestors are evolutionarily identical to you. You possess the same pattern-seeking monkey brain that they did. You and I are susceptible to the same exact irrationality as them.
Don’t let investing placebos fool you into thinking you know more (or less) than you actually do.
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-Jesse
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This is exactly why I have honed in on investing in only low-cost index funds. Anything more active than that and you are taking a placebo of sorts. Loved Predictably Irrational, and nice job working the placebo effect into an investing analogy!