Animal Spirits in Finance: Understanding the Psychological Drivers Behind Market Movements

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…