Pavlov's Dog and the Efficient Market Hypothesis
Based on some of my son's actions over the last few days, I wonder if Pavlov's Dog experiment is strongly tied to the Efficient Market Hypothesis
At least once every day, my wife compares our two week old son to Pavlov’s dog. The most common correlation she draws is that every time he hears the sound of the breast pump, he starts salivating (the hospital has advised us to give some expressed milk from a bottle along with the regular “direct” feed).
Occasionally we have noticed a few other such correlations as well. The other day he was whimpering (a word our daughter commonly uses to describe his sighs) and crying, and we realised it was possibly because he needed a change of diapers. My wife took off his socks, and he immediately started quietening down - for he knew that this is the first step in the process of changing his diaper.
A few minutes later, while changing his diapers, I noticed that he had a rash on his bum, and proceeded to apply some diaper rash cream. The moment I had taken the cream in my hand, he smelt it and quietened down, knowing that I would apply it very soon.
All these incidents above, apart from the Pavlov’s dog experiment, remind me of the Efficient Markets Hypothesis. One way of stating this hypothesis is that all known information is “priced in” to the stock price, and so there is no point trying to trade on some information you get. In other words, the stock price already assumes that whatever is expected to happen will happen (with the expected probability).
You can think of Pavlov’s dog being the efficient market hypothesis applied to events that are certain to happen (until they don’t)
The moment our son hears the breast pump, he “prices in” the fact that he is going to be fed very soon, and so starts salivating. When his socks are taken off, he knows his diaper will be taken off him, and so stops whimpering.
Similarly, Pavlov’s dog, when it hears the sound of the bell, prices in that it is going to be fed very soon, and so starts salivating.
The only thing I don’t understand, in the Pavlovian case, is about what happens when the correlation breaks. Let’s say the dog has priced in that he will get the food at the sound of the bell. And he starts salivating. What happens if, a few times, he is not given this food? Will he learn that this correlation is spurious, and thus be more circumspect at the bell?
I’m pretty sure someone has done this research!
No! The whole point of the Pavlov's dog theory is that the behaviour continues long after the underlying cause has gone. It won't continue for ever, but for longer than it is efficient. For example, in the past, when Modiji announced an 8pm speech, there were major market-moving announcements. A market that behaved like Pavlov's dog will get volatile every time an 8pm speech is announced. An efficient market will take into account that in the recent past, the 8pm speeches have been duds. It will also take all other available information into account in an instant before settling on a price level. You cannot bet against an efficient market, but you can against a market that behaves like Pavlov's dog.