Animal spirits: Explained | TIOmarkets

BY TIO Staff

|June 28, 2024

In the world of trading, there are many terms and concepts that traders need to understand to navigate the financial markets effectively. One such term is 'animal spirits'. This term, which originates from the field of economics, has been adopted by traders to describe the psychological and emotional factors that drive financial markets. This article will provide a comprehensive and detailed explanation of this term, its origins, its relevance to trading, and how traders can use an understanding of 'animal spirits' to their advantage.

'Animal spirits' is not a term that you will find in a traditional economics textbook. It was first introduced by the renowned economist John Maynard Keynes in his seminal work, "The General Theory of Employment, Interest and Money", published in 1936. Keynes used this term to describe the instincts, proclivities, and emotions that influence and guide human behavior in the business world. In the context of trading, 'animal spirits' refers to the collective psychological and emotional factors that move the markets, often in ways that cannot be explained by fundamental or technical analysis alone.

Origins of the Term 'Animal Spirits'

The term 'animal spirits' has its roots in ancient philosophy. The Latin term 'spiritus animalis' was used by philosophers to describe the vital spirit or life force that animates living beings. However, the way Keynes used the term 'animal spirits' in his economic theory was quite different. For Keynes, 'animal spirits' were not a life force, but rather the irrational and subjective impulses that can influence economic decisions.

Keynes believed that 'animal spirits' play a crucial role in driving economic activity. He argued that in times of uncertainty, when the future is unclear, people often make decisions based on their 'animal spirits' rather than rational calculation. This idea was revolutionary at the time and marked a departure from the classical economic theory, which assumed that people always act rationally and in their own best interest.

The Keynesian Perspective

Keynes's concept of 'animal spirits' was a key element of his broader economic theory, known as Keynesian economics. According to Keynesian theory, government intervention is necessary to stabilize the economy and prevent economic downturns. Keynes argued that during recessions, 'animal spirits' can cause consumers and businesses to cut back on spending, leading to a vicious cycle of economic decline.

Keynes believed that by understanding and managing 'animal spirits', governments could counteract this tendency and stimulate economic growth. This idea has had a profound impact on economic policy around the world and continues to influence the way governments respond to economic crises today.

'Animal Spirits' in Modern Economics

While the term 'animal spirits' is not commonly used in modern economic theory, the concept it represents is still very relevant. Many economists now recognize that psychological and emotional factors can have a significant impact on economic behavior. This recognition has led to the development of a new field of economics, known as behavioral economics, which seeks to incorporate insights from psychology into economic theory.

Behavioral economists have conducted numerous studies that provide empirical evidence for the existence of 'animal spirits' in economic behavior. These studies have shown that people often make economic decisions based on emotions, biases, and heuristics, rather than rational calculation. This research has further reinforced the importance of 'animal spirits' in understanding economic phenomena.

'Animal Spirits' in Trading

In the world of trading, the concept of 'animal spirits' is used to explain why financial markets often behave in ways that cannot be predicted by fundamental or technical analysis alone. Traders recognize that 'animal spirits' can cause markets to move based on emotions such as fear, greed, and hope, rather than rational assessment of market conditions.

Understanding 'animal spirits' can help traders to anticipate market movements and make more informed trading decisions. For example, during periods of market euphoria, when 'animal spirits' are running high, prices may rise beyond what can be justified by fundamentals. Conversely, during periods of market panic, when 'animal spirits' are running low, prices may fall below their intrinsic value. By recognizing these patterns, traders can take advantage of opportunities to buy low and sell high.

The Role of 'Animal Spirits' in Market Bubbles and Crashes

'Animal spirits' are often cited as a major factor in the creation of market bubbles and crashes. A market bubble occurs when prices of a particular asset rise far above their intrinsic value, driven by speculative buying. This can create a self-reinforcing cycle, as rising prices attract more buyers, pushing prices even higher. However, when the bubble bursts, prices can fall dramatically, leading to a market crash.

Many economists and traders believe that 'animal spirits' play a key role in this process. During the bubble phase, 'animal spirits' can drive prices up as traders become overly optimistic and start to ignore the fundamentals. When the bubble bursts, 'animal spirits' can exacerbate the crash as traders panic and rush to sell. Understanding the role of 'animal spirits' in these situations can help traders to identify and avoid potential market bubbles and crashes.

Strategies for Managing 'Animal Spirits' in Trading

While 'animal spirits' can create challenges for traders, they can also provide opportunities. By understanding and managing 'animal spirits', traders can improve their trading performance. One strategy for managing 'animal spirits' is to develop a disciplined trading plan and stick to it, regardless of market conditions. This can help to prevent emotional decision-making and keep 'animal spirits' in check.

Another strategy is to use technical analysis to identify patterns in market behavior that may indicate the presence of 'animal spirits'. For example, sudden and unexplained changes in price or volume may suggest that 'animal spirits' are at play. By recognizing these signs, traders can adjust their trading strategies accordingly.

Conclusion

In conclusion, 'animal spirits' is a term that originates from economics but has found a home in the world of trading. It refers to the psychological and emotional factors that drive financial markets, often in ways that cannot be explained by fundamental or technical analysis alone. By understanding 'animal spirits', traders can better anticipate market movements and make more informed trading decisions.

While 'animal spirits' can create challenges for traders, they can also provide opportunities. By developing strategies to manage 'animal spirits', traders can improve their trading performance and increase their chances of success in the financial markets.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.