John Maynard Keynes, one of the world’s most celebrated economists, wrote about the phenomenon called "animal spirits" back in the 1930s. Animal spirits' existence is still a topic studied today. Keynes realised many financial transactions were based on irrational waves of optimism or pessimism, rather than mathematical calculations. But Keynes did not invent the term, instead drawing on thoughts about human behaviour that were developed over many years.
Greed and fear
These animal spirits – often called greed and fear by financial experts – can affect confidence. This in turn drives investors' risk appetite and a willingness or reluctance to spend and invest. In a book called Animal Spirits, Nobel laureate George Akelof and fellow economist Robert Shiller explain how confidence can affect the economy whether it is rational or irrational.
A 2010 research paper compared economic forecasts with actual data to show how waves of optimism and pessimism lead people to form forecasts that deviate from what an economic model would show.
History reveals numerous instances when waves of irrational optimism see investors flock to buy an asset – only for an equally irrational outbreak of pessimism to follow. Cycles of greed and fear include the tulip bulb fever of the 1630s, South Sea Bubble of the 1720s and the rise and fall of technology stocks at the end of the last century. In these cases, prices did not just rise and fall but they soared far beyond any rational level and crashed at an excessively fast pace. A BBC graph shows how the Nasdaq index of United States technology stocks rose and fell by some 300% in the two years either side of its peak in March 2000.
Animal spirits can change quickly and make investments that have performed well suddenly perform poorly or even lose money. The difficulty for both non-specialist and professional investors is identifying price rises that are based on irrational exuberance before it is too late. Investors and commentators and professional analysts can fail to spot a bubble because they try to provide an explanation for past moves in price in the context of scientific economic models when, in fact, animal spirits dominate.
Shun the herd
Animal spirits can make it hard for investors to know how to prevent being caught up in a bubble. One tip is to avoid buying something just because everyone else does. This is known as a "herd mentality" or "conformity trap" that ING Group chief economist Mark Cliffe discusses in his fifth video lesson for investors from the financial crisis. Investors should not over estimate the importance of the past performance of an asset when trying to determine future performance.
Under the idea of diversification, investors aim to dilute the impact a fall in the price of one asset would cause by buying different types of investments that have different levels of risk. A column by economist Chris Dillow for eZonomics about dividing investments between safe and risky assets gives further details about ways to build a portfolio.