Don't Let Dummy Pills Make You a Dummy Investor

Wired magazine ran an article last week about the science behind the placebo effect. If you're geeky enough, you'll find these kinds of stories fascinating. But even for average investors who couldn't care less about why the placebo effect works, it's still important to keep placebos in mind when evaluating companies, especially since Wired points out that their effect is getting stronger.

To get a drug approved by the Food and Drug Administration, companies are generally required to run two phase 3 clinical trials comparing the drug to a placebo, commonly called a sugar pill, which shouldn't have any effect on the disease.

In reality, those mock treatments often cause patients to feel differently. The expectation that the drug is working triggers a positive chemical response in the body. The placebo effect may be getting stronger these days because patients have grown accustomed to having drugs help them. Pharmaceutical companies may even have enhanced the "placebo monster" with their direct-to-consumer advertisements.

Whether a drug passes its clinical trial is determined by the difference between the effect of the drug and the effect of the placebo, so a growing placebo effect is raising the bar for drugs to be approved. Here are a couple of drugs in development that should concern investors when it comes to the placebo effect's ability to derail a perfectly good drug.

Source: ClinicalTrials.gov.

Note that these are "higher order" conditions, usually involving the brain and patient expectations.

Weight loss is also a situation for which drug companies might have to worry that the placebo group will perform better than expected. In this case, it may not be the placebo helping the body but being in the weight-loss study itself that may cause patients to alter their actions and lose weight, by eating less and exercising more.

For other drugs, investors need to be less worried about whether there's a strong placebo effect in the control group. In these cases, the act of getting a placebo may make the patient a little happier, but it isn't likely to have as strong an effect on the cure rate.

That isn't to say that investors shouldn't insist on having a control group for these types of drugs. Some companies will run an uncontrolled phase 2 trial for cancer drugs and compare the findings to the average survival rate for the particular type of cancer that they're treating. The problem is that without a matched pair to compare the participants to, it's difficult to draw a firm conclusion.

What's a drug company to do?
If the act of taking a placebo is invoking a stronger response, one solution would be to run larger clinical trials. A small difference between a drug and placebo can be statistically significant if the population being tested is large enough.

Put another way, if you were to flip a coin 20 times and came up with 58% heads, you'd blame it on randomness. If you flipped it 2,000 times and still got 58% heads, you'd start to believe there really was a difference between heads and tails, at least with that coin.

The larger trials will cost pharmaceutical companies more money, but it seems like a small price to pay to ensure that they're able to demonstrate a verifiable effect for their drugs.

Factor it in
Determining whether drug companies will be successful in their clinical trials is extraordinarily difficult; it's one of the reasons small drugmakers can have such stellar returns. You can just add the placebo effect to a laundry list of reasons that drugs fail to make it to market: efficacy, side effects, or even commercial nonviability after a positive clinical trial.

Instead of being scared that the sugar pill will perform better than expected, investors should factor it in and require a larger margin of safety before investing in companies with drugs that may be affected by it.