Investors Dilemma: Pavlov’s Dogs & The Ringing Of The Bell

Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g. food) is paired with a previously neutral stimulus (e.g. a bell). What Pavlov discovered is that when the neutral stimulus was introduced, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.

What does this have to do with investing. Let’s start with a tweet I got recently in response to the article “Fed Trapped In A Rate Cutting Box.”

This is a great example of “classical conditioning” with respect to investing.

In 2010, then Fed Chairman Ben Bernanke introduced the “neutral stimulus” to the financial markets by adding a “third mandate” to the Fed’s responsibilities – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

Importantly, for conditioning to work, the “neutral stimulus,” when introduced, must be followed by the “potent stimulus,” for the “pairing” to be completed. For investors, as each round of “Quantitative Easing”was introduced, the “neutral stimulus,” the stock market rose, the “potent stimulus.”

More than 10-years, and 300% gains later, the “pairing” has been completed.