Animal Spirits in the Markets

Behavioral Finance
Patrick Labbe, CFA

The convenient assumption that human beings are rational actors is a foundation of traditional economics, and the ideas and theories derived from this assumption have proven quite useful. Still, witnessing large daily stock price swings or simply experiencing life’s more emotionally stirring moments makes clear that humans are much more than rational calculators seeking constant optimi­zation. This is not a unique observation, even among economists. The relatively new field of behavioral economics has been successful in compiling evidence that emotions and convenient mental shortcuts often result in less than optimal decisions. With a growing number of behavioral economists winning Nobel prizes and the increasing influence of their research on public policy, it’s clear the traditional view of Homo Economicus is incomplete without accounting for Homo Sapiens.

One of the most interesting insights into non-economic motivations in human decision making was made well before the field of behavioral economics existed. In his 1936 book, The General Theory of Employment, Interest and Money, legendary economist John Maynard Keynes described the presence of “animal spirits” in human actions. Not limiting himself to economics, Keynes noted that a number of human activities “... depend on spontaneous optimism rather than mathe­matical expectations, whether moral or hedonistic or economic.” Specific to investing, he noted: “Our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City amounts to little…” Facing such uncertainty, Keynes believed that some actions “can only be taken as the result of animal spirits.” The main idea is that broadly held expectations about the future create a sort of collective confidence (or pessimism) that manifests itself in economic activity, risk taking and prices.

The 2017 economic environment might be a good example of Keynes’ animal spirits gaining confidence. A persistently strong stock market suggests a sense of collective optimism. Similarly, some recent measures of consumer and business confidence are within 10% of their all-time highs. Adding to the enthusiasm are recent changes in both tax policy and regulatory philosophy. Time will tell how much economic growth will result from these changes, but it’s clear that businesses, consumers and investors are feeling increasingly confident.

Macroeconomic statistics such as confidence indexes are not reliable predictors of stock prices or changes in the economy. They are, however, often useful in understanding asset prices, especially when prices seem to move more than economic factors alone warrant. Also, the prevailing mood of investors, as reflected in their apparent willingness to take risks, can be important. Our assessment of these factors suggests investors can expect to hear more about “animal spirits” and their influence in the near term. As for us, we’ll abide by one of Warren Buffett’s axioms: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.”