Animal Spirits

What Are Animal Spirits?

"Animal spirits" is a term coined by the British economist John Maynard Keynes to describe emotional or "gut" instincts by investors and businesspeople to take risks rather than based on any empirical evidence.

Writing in his 1936 classic, "The General Theory of Employment, Interest and Money," during the Great Depression, Keynes described animal spirits as "a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."^[1]

Essentially, investment and business decisions are made to some degree by "spontaneous optimism rather than mathematical expectations." Conversely, Keynes added: "If the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die."^[2]

For example, economic conditions as described by recent statistical reports may be too negative to make an investment, but an investor may instead view that as a positive signal to buy, thinking that the market has hit bottom. Conversely, economic indicators may all be positive and the stock market at all-time highs, but some investors may view that as a sign that the market or business conditions have become too pricey and about to turn negative.

In fact, sentiment plays a huge role in moving markets and making business decisions. Many institutions and organisations throughout the world, both public and private, closely track consumer and business sentiment through surveys as a possible indicator of future trends and business activity.

In the U.S., for example, the Conference Board produces a monthly consumer confidence index, while the University of Michigan publishes a bimonthly index of consumer sentiment, both of which are widely followed by investors, the retail industry and others. Likewise, the U.S. Chamber of Commerce tracks sentiment among small business owners.

Behavioural Economics

The role of sentiment and psychology in financial decision-making has also sparked an academic field called behavioural economics, which tries to understand why "rational" people make decisions that are not only not based on empirical evidence but are often at odds with their own best interests.^[3]
Several people have won the Nobel Prize for economics because of their study in this field.

1. Herbert Simon won the award in 1978.^[4]
2. The Israeli economist Daniel Kahneman shared the award in 2002 for integrating psychological research into economics.^[5]
3. Richard H. Thaler, an economist at the University of Chicago, won the prize in 2011 for his work building on that of Kahneman and Simon.^[6]

Summary

Animal spirits is a term coined by the British economist John Maynard Keynes to describe the role of emotion and "gut instincts" in taking risks and making business and investment decisions, in addition to empirical evidence. Animal spirits has spawned its own academic discipline called behavioural economics.