Pavlov's New Dog

Exploring the "conditioning" of today's investors and the changing rules of the game.

By Stephen Weitzel, CFP®

Foreword: I began writing this white paper nearly 4 years ago, but it was somehow, some way, lost to time. Perhaps that initial draft is still saved on my hard drive, nested closely to some bitcoin I had unknowingly mined. Thank you to my friend, Jason Perz, for his continued prodding for me to complete this writing.

In one of the most iconic studies in behavioral psychology, Ivan Pavlov showed that behavior could be shaped through association. By repeatedly ringing a bell before feeding dogs red meat, Pavlov found that over time the dogs began to salivate at the sound of the bell alone, even when no food was present. This experiment introduced the concept of conditioned responses, a principle that applies not just to animals, but to humans as well.

Take children, for example. Many dread visiting the doctor because they associate it with painful shots. Parents often counter this with promises of a reward – perhaps a visit to the toy store, or an ice cream shop. This is another form of conditioning: pairing discomfort with a future benefit to shape behavior.

Many investors have been conditioned to favor what has rewarded them in the past, and to avoid what has caused them financial pain. While this might seem logical and is, in fact, consistent with Harry Markowitz’s Modern Portfolio Theory, the real world doesn’t operate inside an academic vacuum. Inside the classroom, Dr. Markowitz could mute the human condition and ensure that investors be capable of rational decision making. For those of us living outside of those scholarly walls, we share a different lived experience. What might start out as rational behavior with the best of intentions can very quickly turn into a situation of unforeseen consequences.

For example, investors might initially rebalance their portfolios based on performance, allocating more to the best-performing assets. As those investments continue to outperform, they may begin to concentrate more and more into those winning positions, reinforcing a belief that this behavior will always yield positive results. The bell rings, and they salivate. This isn’t disciplined investing. Instead, I believe this is Pavlovian investing, and it has led too many investors to align their portfolios with consensus group-think, placing less emphasis on managing risk.

Since the global financial crisis, U.S. large-cap stocks have been that ringing bell. The S&P 500 has vastly outperformed nearly every other major asset class: bonds, international equities, REITs, and commodities. Charts tracking the S&P 500’s performance relative to these alternatives show a clear and consistent upward trend (see appendix for additional examples).

Encouraged by this prolonged outperformance, many investors have adopted passive investment strategies, particularly those tied to the S&P 500, with little concern for potential risk. The mindset has become: “If this approach has worked so well for so long, how risky could it possibly be?”

Supporting this behavior is a decade’s worth of data from Morningstar, showing a dramatic shift in investor assets away from actively managed funds toward passive strategies.

This shift has been underpinned by three core beliefs:

1. U.S. stocks are a superior long-term investment.

2. Passive strategies are cost-effective and tax efficient.

3. Diversification has become a drag on returns.

These beliefs have been reinforced through prolonged recency bias, or “experience,” and it has lasted nearly two decades of favorable outcomes. But that doesn’t mean they’ll hold true forever.

Financial professionals largely understand that market leadership rotates and dominance by U.S. stocks is unlikely to last indefinitely. Unfortunately, many financial advisors still find themselves in a quandary between maintaining professional prudence and placating a client base that has become conditioned towards aforementioned outcomes.

Another powerful force shaping investor expectations has been the decline in interest rates for the past 45 years. From nearly 16% in the early 1980s, the yield on the 10-year U.S. Treasury dropped to near zero by 2020. As rates fell, bond prices rose, fueling one of the longest and most stable bull markets in financial history. From 1981 to 2021, U.S. bonds posted positive returns in 36 out of 40 years. During major stock market downturns, bond values increased, providing crucial ballast to diversified portfolios. The table below highlights several examples.

This is why passive allocation strategies gained popularity: they seemed to work. Stocks for growth, bonds for stability. The lack of correlation the bond market has shared with stocks since the early 1980’s is a concept now so ingrained within the investment community that it is considered “knowledge.” Challenging this notion has been heretical. But what if the environment has shifted, and 2022 was the first shot across the bow that yesterday’s passive risk management solutions are no longer effective? That year, the S&P 500 declined by over 18%, its worst drop since 2008. However, the US Aggregate Bond Index fell almost 13%, its largest drop since the index’s inception.

The Billion Dollar Question

After learning to associate the sound of the ringing bell with food, how many times would it take for Pavlov to ring the bell and not provide the dog with any food (reward) before the dog would unlearn the behavior? As conditioned as investors have become to accept certain outcomes, how many times will they have to be disappointed before they abandon the convictions they maintain today?

Two major challenges now face investors—one self-inflicted, the other structural:

1. Overexposure to U.S. Stocks

Years of strong returns from U.S. equities have led to record-high stock allocations among U.S. households. History suggests that when stock exposure is this high, future returns tend to be disappointing. The chart below from Willie Delwiche at Hi Mount Research illustrates this inverse relationship between equity exposure and subsequent 10-year S&P 500 returns. For instance, in 2000, high stock allocations coincided with negative returns over the next decade. In contrast, reduced exposure in 2008–2009 preceded a period of exceptional returns.

Despite this historical lesson, today’s investors are heavily allocated to stocks—often through passive strategies—raising the risk of underperformance if the market falters.

2. The End of Bonds as a Safety Net

Traditionally, bonds have provided stability when equities stumbled. But that assumption may no longer hold. With interest rates in a long-term uptrend, the bond market could face persistent headwinds. Recent returns already reflect this risk.

Relying on bonds for downside protection may now be misguided. Rates have been rising since 2020, and the bond market has already shown signs of strain. From mid-2020 through early 2025, the U.S. Aggregate Bond Index has produced a cumulative loss exceeding 5%. The once-reliable relationship between falling rates and rising bond prices is reversing.

If a new secular trend of rising rates has begun, maintaining continuous exposure to the bond market may not provide the same level of “risk-off” diversification it once did. Instead, investors and advisors must recognize that cash—yes, cash—is a legitimate asset class. With short-term interest rates offering meaningful yields for the first time in decades, cash can serve as both a safe haven and a portfolio stabilizer without the capital risk inherent in longer-term bonds.

Going forward, preserving purchasing power and managing portfolio risk may require embracing unconventional tools. Investors may need to look beyond traditional bonds toward assets like commodities, foreign currencies, or other non-correlated alternatives. This would result in a structural shift in the investment industry and the manner it engages with clients and regulates financial advisors

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Conditioning is powerful—but not permanent. Pavlov’s dogs would eventually stop salivating when the bell was no longer connected to food. Likewise, investors will adjust when their long-held beliefs stop yielding rewards. Whether through repeated disappointments or a single, significant setback, change is coming. Investors who prepare for that change—by reassessing risks, reducing overconcentration, and rethinking portfolio design—will be better positioned for the road ahead.

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Appendix

Disclosures

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Reveille Wealth Management, and not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification. Past performance is not a guarantee of future results. Individual investor's results will vary.

All investments are subject to risk, including loss. There is no assurance that any investment strategy will be successful. It is important to review the investment objectives, risk tolerance, tax objectives and liquidity needs before choosing an investment style or manager. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.

S&P 500: This index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. It consists of 400 industrial, 40 utility, 20 transportation, and 40 financial companies listed on U.S. market exchanges. This is a capitalization-weighted calculated on a total return basis with dividends reinvested. The S&P represents about 75% of the NYSE market capitalization.

Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.

Holding stocks for the long-term does not insure a profitable outcome. Investing in stocks always involves risk, including the possibility of losing one's entire investment.

Investing in commodities is speculative due to high potential for loss. Markets are volatile, with sharp price fluctuations even during overall price increases.

Investing in REITs can be subject to declines in the value of real estate. Economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.

Indices are not available for direct investment. Index performance does not include transaction costs or other fees, which will affect actual investment performance. Past performance is not indicative of future results.

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