Blog - Investing Notes
December 20, 2004 –
The Importance of Animal Spirits?
In their October 2003 paper entitled "Determinants of Stock Market Volatility and Risk Premia",
Mordecai Kurz, Hehui Jin and Maurizio Motolese model and examine "the
dynamics of diverse [but still rational] beliefs" as the driver of asset
market volatility. Specifically, they postulate that:
- It is unreasonable to assume that investors in a
complex, dynamic economy will exhibit all-knowing rationality.
Rather, rational investors hold beliefs generally compatible with,
and forecasts not disprovable by, available empirical data. This
level of rationality accommodates considerable diversity of beliefs
among equally informed investors.
- A bull expects returns on investments to be higher
than the norm of past returns; a bear, lower. To maintain
rationality as new data becomes available, bulls and bears must
change their beliefs over time.
- The aggregate "market state of belief" across all
investors determines the asset risk premium, and the dynamics of
this state of belief drive price volatility.
By modeling and exploring this conceptual framework, the
authors conclude that:
- Overconfidence intensifies investor expectations,
thereby inducing high price volatility. Refer to investor
discussion boards, market analyst forecasts and business press
commentaries for examples of overconfidence and intensity.
- Investors are bearish (expecting lower than
normal returns) more than 50% of the time. Consequently, when
bullish, they expect large excess returns over relatively short
periods. This asymmetry reflects the fact that major stock
market advances occur relatively quickly following market declines.
The authors note that while these two conclusions "can
be satisfied by different belief formation models, the simplest way
to think of them is as an expression of animal spirits." Perhaps overconfidence
compensates for the paralyzing effect of uncertainty. Perhaps a predominant
pessimism fuels preparation and risk management.
In summary, investor emotions drive market volatility,
but there is an asymmetry to fear and greed.
See our blog
entry of 10/9/04 for a related discussion of investor herding.
