Of Pepsodent & Portfolios: The habit loop in equity investing

The current market dynamics persistently reinforce the habit loop, and a transformation in this pattern is foreseeable only when the rewards derived from the habit become unfavourable (i.e., negative returns). Until such a shift occurs, investors focusing on “silly things” like fundamental analysis, valuations, and optimal capital allocation may find themselves perplexed by the ongoing trajectory.

“I made a million dollars off Pepsodent,” boasted Canadian ad man Claude Hopkins (1866-1932). A million dollars was a lot at the time, but it was his innovative approach that shaped consumer habits and even today, continues to influence marketers across generations. Hopkins propelled Pepsodent to global success through his seminal work in advertising.

Initially, when approached by an old friend for the Pepsodent campaign, Hopkins displayed only mild interest. At the time, the deterioration of Americans' dental health was evident, attributed to increased national income and the consumption of sugary, processed foods.

The situation reached a critical point during World War I, as decaying teeth were cited as a national security risk. Despite widespread dental issues, the challenge lay in the fact that toothpaste sales were sluggish as people never brushed their teeth, rendering door-to-door sales of tooth powders useless.

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Ultimately, Hopkins accepted the campaign. His strategy was straightforward—he instilled a desire and fuelled the habit loop. As Charles Duhigg notes in his book "The Power of Habit," many decisions that appear rational are, in fact, shaped by ingrained habits.

Deep within our brains lies the basal ganglia, a neurological tissue that preserves habits, even when the brain goes to sleep. This was an evolutionary adaptation, aimed for efficiency that minimised brain size to facilitate childbirth and reduce mortality rates for both infants and mothers.

The brain developed the practice of converting sequences into automatic routines, known as chunking, triggered by cues (indicating when to transition to habit mode). This process follows a three-step loop: a cue initiates an automatic mode, followed by a routine (physical, mental, or emotional), and culminating in a reward that aids the brain in determining the loop's memorability.

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Hopkins' cursory reading on dental hygiene revealed mucin plaque, a film causing dental yellowing and decay. His ad campaign capitalised on this "cue," inviting consumers to feel the film on their teeth, positioning Pepsodent as the "routine" for achieving a "rewarding" pretty smile.

The result: explosive demand within three weeks, international expansion within three years, and Pepsodent becoming one of the world's top-selling products within a decade. It remained America's best-selling toothpaste for three consecutive decades.

The intriguing part is that a prominent dental researcher, pre-launch, said that all toothpastes – particularly Pepsodent – were worthless to remove the film. According to them, teeth could be cleaned through simple actions like eating an apple, running one's finger over the teeth, or a vigorous mouthwash swirl. Nevertheless, in 2022, global toothpaste sales, including Pepsodent, exceeded $18 billion.

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Habits influence not only on our daily routines, but also extend to other activities, including the decision-making process for investments.

As India transitioned away from the black economy through initiatives like demonetisation and the implementation of GST, traditional investment avenues, particularly in real estate, became less rewarding. The crash in Indian equity markets during Covid, coupled with the widespread economic shutdown, led to an influx of new investors into the equities arena.

With a favourable starting point, the initial experience in the market was exceptional. Market recovery and a rally in small caps resulted in substantial gains for investors, establishing a habit loop: a market downturn serving as the “cue”, subsequent investment as the “routine”, and the “reward” of handsome returns.

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We have seen this on multiple occasions. In 2022, a 35 percent decline in Nasdaq, driven by escalating global interest rates, was countered by a 2 percent rise in Indian equities, propelled by domestic institutional investor (DII) inflows ($36 billion, despite foreign Institutional Investors — FIIs — selling $17 billion).

Indian investors demonstrated similar behaviour in response to the 1,300-point Nifty drop in September-October 2023, and the 300-point fall on December 20th. Remarkably, unprecedented inflows into mutual funds and direct stock purchases persist. Indian stocks only go up, right?

However, this behaviour comes with consequences. The constrained availability of free-float in listed equities (supply), coupled with sustained increased flows (demand), leads to an escalation in asset prices.

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Consequently, the demand spills over to relatively weaker businesses. Narratives are constructed, influencing even seasoned observers, who take way-into-the-future positions, which are inherently challenging to predict. The growing fear of missing out prompts widespread participation, thereby further reinforcing the established habit.

This situation poses a significant challenge. While historical narratives have propelled markets to unsustainable heights, their subsequent decline often requires only superficial triggers. In 2018, factors such as the reintroduction of the long-term capital gains tax on mutual funds prompted a more than 60 percent slide in 250 stocks within 18 months.

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Notably, nearly 100 of the top 150 stocks between January 2007 to January 2008 failed to yield positive returns even after 12 years, prior to the Covid-induced market downturn. The capital goods index, which peaked in 2008, regained similar levels only in 2021. The small-cap index, after a substantial surge in 2017, corrected by over 50 percent between January 2018 and March 2020. The exuberance that fuelled the consumption sector between 2014 and 2019 continues to impact returns negatively even today.

Nonetheless, the current market dynamics reinforce the habit loop, and a transformation in this pattern is foreseeable only when the rewards derived from the habit become unfavourable (i.e., we see negative returns). Until such a shift occurs, investors focusing on things like fundamental analysis, valuations, and optimal capital allocation may find themselves perplexed by the ongoing trajectory.