Is The Fear And Greed Index Legit?
If you’re a Warren Buffet fan like myself, then you’ve probably familiar with his recommendation regarding fear and greed:
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” – Warren Buffett
Research shows that we use the part of our brain that emotions stem from to make day to day decisions instead of using logic.
It should come as no surprise that many of us make our investment decisions based on emotions as well.
Is that the right thing to do?
What did all the “financial experts” tell you to do during the COVID-19 pandemic? Did they instill fear or calm in you?
How do fear and greed apply to investing?
Let’s take a look…
Fear and Greed Effects
Whether you realize it or not, most investors are driven by two emotions: fear and greed.
Think about the last time you made any type of investment and ask yourself if you were acting out of fear or greed. It’s safe to say that most investors that sold during the coronavirus pandemic did so based on FEAR.
Unfortunately, if they sold low then they locked in their losses.
Too much fear can drive stock prices much lower than they should be.
On the other hand, just the opposite happens when investors get greedy. They can bid up stock prices much too far.
Fear = Sell = More Supply of Stocks for Sale = Stock Price Decreases
Greed = Buy = More Demand for Stocks = Stock Price Increases
Fear and Greed Index
What is the Fear and Greed Index?
This index is brought to us by our good friends over at CNN Money.
At is core, the Fear & Greed Index is an attempt to measure investor sentiment (general mood among investors regarding a particular market or asset) and volatility.
This is where we get the terms “bullish” or “bearish” from. Rising prices indicate bullish market sentiment (thus a positive investor sentiment), while falling prices indicate bearish market sentiment.
In other words, the index measures investor emotions of fear and greed on a daily, weekly, monthly, and yearly basis.
These financial experts claim that this index can serve as a tool for making sound investments while Bogleheads beg to differ claiming it useless.
CNN looks at seven factors scored 0-100 and the average is scored on a speedometer-like scale.Join the Passive Investors Circle
Seven factors of the index
The seven factors are:
- Stock Price Momentum: The S&P 500 vs its 125-day moving average
- Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange
- Stock Price Breadth: How far has share volume advanced or declined on the New York Stock Exchange (NYSE)?
- Put and Call Options: The put/call ratio, which compares the trading volume of bullish call options relative to the trading volume of bearish put options
- Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds
- Market Volatility: The VIX which measures volatility
- Safe Haven Demand: The difference in returns for stocks versus Treasuries
Here’s what today looks like as of this writing:
According to the index, we’re now in FEAR mode!
Fear & Greed Over Time
How does this look over time?
My good friend Dr. Graham over at FI Physician has this to say about the fear and greed index over time:
“Now we see why the Fear & Greed Index is useless. See how it massively swings from extreme fear to extreme greed and back again. It is average investor sentiment; a retrospective score of how the stock market is doing.”
“This is not a shockable rhythm for ACLS purposes. A seizure? It’s not a brain wave or a fever curve, or a measure of respiration. No intervention is required.”
“The Fear and Greed Index is a statistic looking for a news story.”
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Understanding The Fear And Greed Index
The financial experts that are Pro-Fear and Greed Index feel that by understanding and learning how the index works then we can make better investment decisions.
On the other hand, skeptics of the index dismiss it as a good investment tool. Why? Think about what it’s encouraging…for us to try and time the market rather than using a proven buy and hold strategy (commonly used by millionaires) for long-term growth.
As a long-term investor both in the markets and passive real estate investments, I understand that investors should avoid trying to time the markets to capture short term gains.
But what this index may do is help in deciding when to enter the market. Especially for those that are sitting on a load of cash and want to begin dispersing it.
By doing this, you’re emulating what Warren Buffett stated regarding when he likes to buy stocks. He doesn’t like to buy them when they’re low; he wants to buy them at their lowest.
“The best thing that happens to us is when a great company gets into temporary trouble. We want to buy them when they’re on the operating table.” – Warren Buffett
Behavioral Finance And The Index
There has been much research in the field of behavioral finance but nothing bigger than when psychologists Daniel Kahneman and Amos Tversky in 1979 developed “prospect theory,” which explains how the same person can be both risk averse and risk taking, depending on whether a decision seems more likely to lead to a gain or a loss.
This is where we’ve learned that people respond much more to fear of losing something vs making a gain. Actually, we’ll accept more risk to avoid a loss and this behavior predominates when the Fear and Greed Index leans toward fear.
Those that are for the index state that by understanding the risks associated with investments, investors have better chances of making the right decisions that are not based on emotion.
And by knowing what the fear and greed index is, investors have more real chances for success.
What About You?
What are your thoughts about the Fear and Greed index? What will you do the next time that panic strikes the airwaves? Will you sell like the masses or not?
If you don’t know then consider deciding now on either who you’re going to listen to and what you’re going to read once another crisis happens.
If you don’t have a mentor then consider searching for one now then begin developing the good habits that they recommend.
If you’re starting to realize just how VOLATILE the market is then good for you!
This is one of the handful of reasons I began diversifying into passive real estate via syndications.
If you want to learn more, join our FREE Passive Investors Circle today.