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It's No Random Error

Stocks look random but over the long-term, deliver better returns than fixed interest rate investments like FDs. Both play a role in a balanced approach to investing

Let's talk about rats. Rats are mammals, they are intelligent, and have a remarkable behavioral and biological resemblance to humans. These are the reasons that they are often used not just for biological but psychological experiments as well.

Here's an amazing experiment that I once read about. A group of rats were divided into two groups. Both groups were conditioned to expect food at a certain spot in the complex of cages where they lived. Apparently, rats learn this sort of a thing very easily. At set times of the day the rats would turn up at this feeding station and find food waiting for them. However, immediately after eating, the rats were subjected to electric shocks through the floor of their cages. The shocks were strong enough to be very unpleasant but not lethal.

But the two groups were treated differently. While one group was given an electric shock after every meal, the other one was given the shocks after only half of the times. However, for the second group, the actual instances when they would be subjected to the shocks were chosen randomly. After some of their meals they would get the shocks and after some they wouldn't and they had no cues to help them figure out what would happen on any given instance. The effect of this pattern on the behaviour of the two groups was interesting. The group that got the electric shocks every time quickly adjusted to what was happening and basically got on with life. They would show up for food, eat it, brace themselves for the shock and happily continue with their ratly routine after getting the shock.

The other group did far worse. They just couldn't get used to the randomness of their ordeal. Many of them started avoiding food and would eat only when they were on the verge of starvation. All of them became significantly weaker. Get this clearly: the group that got fewer electric shocks fared far worse than the ones who were given electric shocks every single time. It was the sheer meaningless unpredictability of their lives that did them in.

From this point on, this article could be about almost anything. I could make a comparison between the how happy Bermudian cricket fans looked compared to Indian ones. I could write about how film stars who make crores are whining neurotics compared to regular salary earners. If I wrote about politics I could talk about almost anything that's been done to the citizens of this country. But since investments are my brief, I'll just talk about how legions of investors are abandoning equity and rushing towards debt.

Human beings, not being rats, should be able understand the long-term trends beneath things that look random. The rats that were treated randomly should have kept records, applied some simple statistical formulae and figured out that their long-term average of electric shocks was unchanged and thus their lives were not actually random. They could even have become technical rats and figured out head-and-shoulder, or (since rats don't have shoulders) head-to-long-tail patterns in their electric shocks. But just because the rats somehow missed this trick doesn't mean that we humans have to, too.

Stocks look random but over the long-term, deliver better returns than fixed interest rate investments like FDs. Both play a role in a balanced approach to investing. All we need to do is deal with randomness better than even intelligent animals like rats do.