B. Venkatesh
Consider this. You are running fever and your doctor recommends a medicine that is available only at select medical stores. You recover after a four-day dosage only to realize later that the pills were a mere placebo. Why do we fall for placebos and what are its linkages to investments?
Role of psychology
Placebo is Latin for ``I shall please``. Placebos have been documented to provide effective cure to patients, prompting pharma companies to research to find out why. Psychologists argue that it is our expectations that make the sugar pill work so well.
In one study, people were given light electric shocks on their wrists. They were then given a placebo. Half the people were given a brochure mentioning full cost of the pill while the other half were told that the price was marked down without providing a reason why. The researchers found that the people who were told the full price experienced less pain than the ones who were told that the price was marked down! This and similar experiments brings to the fore the role of psychology in placebo effect.
Why we diversify
How is this related to investments? Suppose we know that a particular stock is sure to move up, we would then use substantial part of our money, if not all, to buy the stock. The fact that we do not place all our money in one stock clearly shows that we are uncertain about asset price movements. We, hence, diversify.
Diversification in some ways is like a placebo. You feel good about diversifying, just like you feel better after swallowing the sugar pill. Why?
Suppose you have 15 stocks in your portfolio. Assume the market crashes and eight stocks in your portfolio fall 20 per cent and the rest fall by less than 10 per cent. You take relief from the fact that you did not lose 20 per cent in the other seven stocks as well! Diversification is the sugar pill that helps us typically drive away our investment blues!
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