In the world of finance, the concept of “animal spirits” was first introduced by the British economist John Maynard Keynes in his 1936 work The General Theory of Employment, Interest, and Money.

Keynes used this term to describe the psychological and emotional factors that drive human behavior in economic decision-making, particularly in markets.

While most economic models assume that individuals act rationally and based solely on objective data, Keynes recognized that emotions like fear, greed, optimism, and pessimism play a critical role in financial markets.

Today, “animal spirits” is a term frequently used to explain the sometimes irrational behavior of investors that can lead to extreme price movements and increased volatility in markets like Wall Street. These animal spirits can drive asset bubbles, market crashes, and sudden changes in investor sentiment that can overpower rational analysis.

Let’s delve into what animal spirits mean in finance and examine how they impact asset prices and market volatility with real-world examples.

What Are Animal Spirits?

At its core, animal spirits refer to the emotional and psychological factors that influence investors’ decisions, often leading them to act irrationally. These emotions can be as simple as the herd mentality, where investors follow the crowd without doing thorough research, or as complex as the emotional responses to news or economic data. While traditional financial theory assumes that markets are efficient and investors always act in their best interest based on available information, Keynesian theory suggests that human psychology can lead to irrational exuberance or excessive pessimism, which results in mispricing of assets.

How Animal Spirits Affect Asset Prices

1. Market Bubbles
A classic example of animal spirits at work is the formation of asset bubbles. When investors collectively become overly optimistic about a particular asset or sector, it can lead to a rapid increase in prices far beyond what fundamentals would suggest. This irrational exuberance leads to speculation, as more investors pile into the asset expecting continued price appreciation, pushing prices even higher.

One of the most famous examples of this is the Dot-com Bubble of the late 1990s. At that time, investors were highly optimistic about the potential of internet companies, despite many of these companies having little to no revenue or profit. The belief that the internet would revolutionize the economy led to a buying frenzy in tech stocks. As a result, prices soared far beyond their intrinsic value. When reality set in and investors realized many of these companies were not viable, the bubble burst, leading to a massive market crash in 2000.

2. Market Crashes and Panic Selling
Just as animal spirits can inflate asset prices, they can also cause sharp declines when fear takes hold. A prime example of this is the 2008 Global Financial Crisis. Leading up to the crisis, there was an exuberant belief that housing prices would continue to rise indefinitely, fueled by easy credit and speculative buying. However, when the housing bubble burst and financial institutions began collapsing, fear spread across Wall Street. This panic led to a massive sell-off, with investors pulling their money out of risky assets.

Despite government interventions and emergency measures, fear dominated investor psychology, leading to one of the most significant market crashes in history. Stock prices plunged, and volatility spiked as investors fled to safety. During these times, investors weren’t making decisions based on rational analysis but were driven by the need to protect their wealth from what they perceived as further declines.

3. Volatility Spikes: The Role of Fear and Greed
The Volatility Index (VIX), often called the “fear gauge,” is a clear reflection of how animal spirits manifest in the market. The VIX measures the expected volatility in the S&P 500 over the next 30 days and tends to spike during periods of market stress, as investors become uncertain about future market direction.

For example, in March 2020, during the early days of the COVID-19 pandemic, the VIX reached unprecedented levels as fear and uncertainty gripped global markets. Investors were unsure about the economic impact of the virus and responded by selling off risk assets like stocks. This led to sharp declines in equity markets worldwide, with Wall Street experiencing some of its most volatile days since the financial crisis of 2008.

The fear was so pervasive that even good news, such as government stimulus efforts, struggled to stabilize the market for some time. It wasn’t until investor sentiment shifted, and confidence in economic recovery began to build, that markets started to recover. The VIX gradually came down as the panic subsided and optimism returned.

The Impact of Animal Spirits on Wall Street Volatility

Wall Street is particularly susceptible to the effects of animal spirits due to its global prominence, media coverage, and the fact that many investors follow the actions of large institutional players. When emotions drive decision-making, asset prices can experience wild swings, creating opportunities for short-term traders but challenges for long-term investors.

For example, during periods of excessive optimism, market participants may push prices to unsustainable levels, only to see them come crashing down when the market corrects. Similarly, in times of extreme fear, even fundamentally strong companies may see their stock prices plummet, providing opportunities for value investors but causing significant stress for the broader market.

Institutional investors, hedge funds, and even algorithms that trade on market sentiment can exacerbate these swings. When a few key players start to sell off positions, others follow suit, causing further downward pressure on prices. The reverse is true during bullish phases, where collective optimism can cause prices to rise far beyond their intrinsic value.

Managing Animal Spirits in Investment Strategies

For investors, understanding the role of animal spirits in financial markets is essential for managing risk. While it is impossible to eliminate emotional reactions, strategies such as diversification, disciplined rebalancing, and sticking to long-term investment goals can help mitigate the impact of irrational behavior. Additionally, using tools like stop-loss orders or employing risk management techniques can prevent emotional decisions from devastating a portfolio.

For more experienced investors, animal spirits can present opportunities. Recognizing when the market is driven by emotion, rather than fundamentals, allows for tactical investments that capitalize on mispriced assets. During periods of fear, strong companies may be undervalued, providing buying opportunities. Conversely, in moments of exuberance, it may be wise to take profits and reduce exposure to overheated sectors.

Conclusion

Animal spirits play a significant role in the movement of asset prices and market volatility on Wall Street. These psychological drivers often lead to periods of irrational exuberance, followed by sharp corrections, making markets unpredictable in the short term. Investors who understand the impact of fear, greed, and other emotions on market behavior are better equipped to navigate volatile conditions and make informed decisions. Whether during market booms or busts, animal spirits will continue to shape the financial landscape, influencing how asset prices move and how investors react to the ever-changing dynamics of global markets.