The Psychology of Animal Spirits and how to manage this risk

Coined by the renowned economist John Maynard Keynes, the term broadly describes how in the most uncertain times it would take a hardened, analytical and probably crazy person to have the backbone to invest capital at a time of such high volatility (and thus risk).

This is to say when the consensus of the ‘animal spirit’ is acceptably high there is a sufficient appetite from investors to invest, which sustains aggregated demand. This is reversed when investors do not have sufficient ‘animal spirit’ which causes investment declines, leading to further declines in the wider economy. It is worth noting that this section covers the above definition, and the more modern inclusion of behavioural economic theory which is concerned with irrationality in the face of uncertainty. The difference being that Keynes believed that the urge to action which explained decisions despite uncertainty was neither rational or irrational. Whereas modern literature is concerned with ‘animal spirits’ in that it is a departure from rationality in times of uncertainty.

An easier to digest definition would be that Animal Spirits refers to the emotions and instincts that guide the behaviour of investors and consumers in a market economy.

 As economist Robert Shiller has pointed out: The world economy has been on a roller coaster rise for years, and it was only when the cart veered downward did the passengers realise that this was a wild and crazy ride that they had embarked upon. Shiller continued that the management, clueless in their approach, did not set limits on how fast they could go or to provide the safety equipment necessary.

The important point to take away from that analogy in that everyone knew the markets could not keep going up forever, but that they purchased houses and took on debt anyway.

Perhaps this was caused by the media, the Governments, and the Economic Experts – it was them most of all who portrayed the success of free markets, democracy and the ever-growing wealth available to us. Governments in Greece miscalculated future growth in the country to such a degree as to verge on bankruptcy, here in the UK debt to GDP ratios were approaching 90% up from 39% in 2005.

The free market system we live under is intricately connected, and specifically banking, investment and insurance. The assets and liabilities of a typical high street bank are of a staggering scale, and much of these assets are owned or owed to another large bank. This vulnerability became apparent during the last financial crisis where banks around the world neared collapse, in part due to this knock-on effect of interconnectedness.

As an investor, what steps can you take?

The most important thing is to have a good plan, and a set of systematic processes that you can use to keep you acting rationally in times of uncertainty. Professional traders have often remarked on the shock and panic that happens to home or propriety traders when volatility, risk and uncertainty suddenly spikes. These traders then go on to make unprepared and ill-judged trades that end up loosing them money.

Professional traders see uncertainty and high volatility of the biggest opportunities, as it provides the biggest opportunities to money in the short time horizon. The broad process of a professional trader is as follows:

  • Notice a sharp increase in volatility in any given asset class
  • Reduce and sell off part of the balanced long/short portfolio to free up capital to invest in this new short-term opportunity.
  • Deploy this freed up capital on the basis of technical analysis for the asset class in question.

As a non-professional trader you may be advised to reduce your risk and exposure until the markets return to normalised levels of volatility. This would happen as follows:

  • Notice a sharp increase in volatility in any given asset class
    In this example we will look at a situation where daily volatility has gone from 1% to 10%.
  • The level of risk in this asset class is now 10 x as high as it was pre volatility spike, and so to remain with the same level of overall risk then you should sell of 90% of your current portfolio. This allows you to remain at the same level of market exposure (or the ability to make gains or losses). Many investors do not take into consideration that increased volatility comes with increased risk, which is a critical mistake.

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