What Is Animal Spirits?
The term “animal spirits” was first introduced by John Maynard Keynes in his book “The General Theory of Employment, Interest and Money.” He used it to describe the driving forces behind the economy, which he believed were not purely economic in nature but also included psychological factors, such as confidence and fear.
Keynes believed that “animal spirits” is an important concept to understand during recessions since it causes people to hoard money and stop spending. This makes it difficult for companies to sell their products, leading to more economic issues. It also refers to the unpredictability that arises when people make decisions based on instinct rather than intellectual understanding.
Animal Spirits in Finance
The term "animal spirits" is used in finance today in relation to market psychology and behavioral economics. The emotions of optimism, pessimism, fear and confidence are represented by the animal spirits. These feelings can influence how people make financial decisions, which in turn can help or hinder economic progress. Even if the fundamentals of the market or the economy are solid, a market that is showing promise will fall if spirits are low. Similarly, market prices will skyrocket if players in the economy have high levels of confidence.
Rationality in Business Decisions
In business, “animal spirits” is the force that drives economic activity. It's what motivates people to start businesses and invest money. It can be thought of as the "gut feeling" that moves people to take action when they see an opportunity or risk in an uncertain environment.
Animal Spirits in Trading
As stated above, animal spirits also refer to the belief that humans are driven not just by logic but also by emotions when making decisions. Emotions can be present in trading as well as any other activity. It’s impossible for traders not to get emotionally attached to their trades and not feel fear or greed when things are going well or badly for them.
When the market is going well, investors and traders can become very confident. In a bull market where prices are rising, most people tend to be optimistic about their investments. That’s when animal spirits are at their peak. Confident investors and traders are less careful about how much risk they take. They just want to ride the bull market and make as much money as possible. When the market turns and things go from bad to worse, confidence is shattered and fear and despair take over. Many investors and traders miss the chance to get out of the market before it goes lower.
The Role of Confidence in Trading
The first thing to understand is that confidence is not necessarily a good thing. It’s important to monitor the level of confidence and try to keep it within a reasonable range. At the same time, it is important to remember that no matter how cautious the trader is, there will be times when trades will go against them. Therefore, traders should use stop-loss to minimize losses.
The Role of Expectations in Trading
Too often, when participants think that the market will go up, it doesn’t. Traders should be ready for such situations and use only a specific percentage of their portfolio in their trades instead of going all in.
Traces of Animal Spirits in Historic Economic Disasters
Market psychology driven by either fear or greed is a common face of animal spirits. In the latter case, the term "irrational exuberance" has been used to describe investor euphoria that pushes asset values much higher than the fundamentals of those assets warrant. The Dotcom Bubble was such an event in which companies’ market worth grew to remarkable levels by just adding "dotcom" to their names - where startups enjoyed high share prices despite reporting no earnings.
Later, the Nasdaq index fell by 76.81% during the crash from a peak of 5,048.62 (on March 10, 2000) to 1,139.90 on October 4, 2002. Most dot-com stocks had collapsed by the end of 2001.
