Animal Spirits and Stock Investing

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John M Keynes may be famous for his metaphors of using “ Beauty Contest “ to explain and describe the investors' perception which caused the price fluctuation in the stock market  and “ Musical Chair “ of how investors speculate in the market.

You may find these two interesting metaphors here ( Keynes on Beauty Contest ) and here ( Keynes on Musical Chair ) if you have never heard about it.

You may also like to read my blog on “ Investing and Storytelling “  ( LINK ) for more detail :

There is another important phrase coined by Keynes which might explain the reasons for the above two phenomena, which is “ Animal Spirits “.  Keynes believed that although most of the economic activity results from rational economic motivations, but also that much economic activity is governed by the animal spirit. Peoples ( investors ) are not always rational in pursuit their economic interest, this animal spirit is the main cause of why the economy ( stock market ) fluctuates much as it does.

According to The Economist: “ Animal Spirit is a colourful name that John M Keynes gave to one of the essential ingredients of economic prosperity: confidence. According to Keynes, animal spirits are a particular sort of confidence, "naive optimism". He meant this in the sense that, for entrepreneurs in particular, "the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death". Where these animal spirits come from is something of a mystery. “

Concept Explained: Animal Spirits by Investopedia & Wikipedia

What does 'Animal Spirits' mean?

A term used by John Maynard Keynes used in one of his economics books. In his 1936 publication ( masterwork ), "The General Theory of Employment, Interest and Money," the term "animal spirits" is used to describe the instincts, proclivities and emotions that ostensibly influence and guide human behaviour, and which can be measured in terms of, for example, consumer confidence. It has since been argued that trust is also included in or produced by "animal spirits".  According to Keynes, animal spirits also generate human trust.

BREAKING DOWN 'Animal Spirits'

There has been a resurgence of interest in the idea of animal spirits in recent years. Several books and articles have been published on this topic. Keynes believed that animal spirits were necessary to motivate people to take positive action.

The original passage by Keynes reads:

Even apart from the instability due to speculation, there is instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic.

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Animal spirits may also refer to the risk involved in making investment decisions which invariably have an element of risk attached.

If people expect a recession, then confidence will be low and saving rise. In this situation, Keynes argued for expansionary fiscal policy to boost demand and economic growth.

This is a fascinating and interesting book written by two Nobel Laureates in Economic Science ( George A Akerlof -2001 and Robert J Shiller – 2013 ). Robert J Shiller also well known for his book title “ Irrational Exuberance “  and  Shiller CAPE PE Ratio – LINK.

The book explains the role of human psychology in markets and how conventional economic theory assigns too much weight to the role of reason in economic decision making, and too little to the role of irrational emotional and psychological factors.

This is how Wikipedia describes the book : “  Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (2009) is a book written to promote the understanding of the role played by emotions in influencing economic decision making. 

According to the authors, economists have tended to de-emphasize the importance of emotional factors, as the effects of emotions are difficult to model and quantify. The book asserts that a variety of otherwise puzzling questions can be answered once one allows for the effect that emotional drives, or "animal spirits," have on economic factors. “

The book also explores how the animal spirit contribute to the performance of the macroeconomy, issues range from business cycles, inflation and unemployment, the swing in financial markets and real estate, the way monetary policy work etc.

They have dedicated two chapters to the world of finance :

Chapter 11: Presents an explanation for why asset prices and investment flows are so volatile.

Chapter 12:  Discusses why real estate markets go through cycles, with periods of often rapid price increase interspaced by falls.

Allow me to quote below from Chapter 11 :

“Obviously, investors are interested in getting rich quickly when the market is soaring. They want to protect value when the market is sagging. This is a psychological reaction to the market’s behaviour. If people tend to buy in reaction to a stock price increase or sell in the reaction to price decrease, then their action to past price changes has the potential to feedback into more price change in the same direction, a phenomenon known as “ price-to-price feedback."

A vicious circle can develop, causing a continuation of the cycle, at least for a while. Eventually an upward price movement, a bubble, must burst, since the price is supported only by expectations of further price increase, as such “animal spirits, “ driven price movement cannot go on forever .”

Animal spirits are human emotions that deep-seated in our mind, they can’t be turned off. “High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich,” the authors write.  Such psychological emotions will continue to influence our decision making in all aspect of our life, including investing.

Another branch of economics study i.e “ Behavioral Finance / Economic “ is trying to explore and lead us to have a better understanding of our “ weird behaviour “ in making financial (investing ) decision.

So, what is your “animal spirits “ that drive you to make a decision on buying or selling of stocks ? or even to invest or save?

Cheers!

Quote Of The Day :

“If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.” 
― John Maynard Keynes, The General Theory of Employment, Interest, and Money