On Animal Spirits

Animal Spirits: A notion of Keynes that implied that the willingness of businessmen to take risk was unpredictable and somewhat irrational, leading to booms and busts.  I don’t agree, at least not entirely, but first a word about rationality and economics.

Thinking hurts, at least for most people.  It takes effort, which is why people conserve on doing it.  Instead, they substitute “shortcuts” for thinking that may have some plausibility.

  • This has worked in the recent past, so it should work in the near future.
  • My friend Fred has done this, and it has worked for him, so it should work for me.
  • James Cramer (or Warren Buffett, or fill in your favorite expert, even me) thinks this will work wonderfully, so I will do it as well.
  • Everyone is doing this and doing well.  I have missed out on it in the past, so I better get going now.
  • The academics say you can’t succeed at beating the market, so I won’t try to do so.
  • I’ve read some books on investing, and there is a really simple formula for beating the market.  I’ll follow that method.
  • No one hedges that risk, so I won’t either.  The risk can’t be that large.
  • The government has always been capable of dealing with economic troubles; they should be capable of dealing with this one as well.

Though my examples come from investing, they apply to other areas of business, finance, and life generally.  Few people like to go back to first principles to think through a problem.  Many follow the crowd, or so-called experts.

As an aside, because people don’t like to think hard, they don’t optimize, as the neoclassical economists posit.  Instead, they choose solutions that they deem to be “pretty good,” and stop their searching.  Searching is a cost.  But neoclassical economists insist  that consumers maximize utility and producers maximize profit anyway.  Why?  If they don’t assume that the math doesn’t work, and they can’t publish something that looks semi-scientific.

Crowd-following is common to humanity.  It takes a lot to stand apart from highly correlated behavior.  I’ve told this story before, but in late 1999, I was talking with my mother (a very good self-taught investor), she told me about many of my cousins who were speculating in tech stocks.  I said to her, “They don’t know anything about investing!”  My mom replied, “Oh, David.  You’re such a fuddy-duddy.  I just bought some Inktomi!”

Now, to set the record straight, that was just 1% (or less) of my mom’s assets, so an occasional flyer is acceptable.  Call it “Mad Money.”  😉  For my cousins, it was most of their investable assets.  My mom is fine, and the fuddy-duddy did all right also, but the cousins swore off stock investing.

I saw the same thing with people in their 401(k)s and other DC plans in 2002 — no more investing in equities.  Real estate was the place to be. Buy what you know, and residential real estate always goes up.

Before I continue with the residential real estate example, here are two questions I ask in order to decide whether a course of action makes sense:

  • What if everyone did this?
  • What is the current risk-adjusted free cash flow yield?

The first point should make you remember that any smart strategy can be overdone.  Any business can be overlevered, etc.  We can ask questions about market size, profit capacity and other things to try to determine what a speculative stock or industry could potentially be worth in the long run.  The same thing is true on the bear side — almost everything has some value even in bear market phases.

The second point has value as well.  I use an equation like this:

Free Cash Flow Yield + Necessary Capital Gains Yield = Funding Yield


Necessary Capital Gains Yield = Funding Yield – Free Cash Flow Yield

By necessary capital gains yield [NCGY], I mean what is needed to keep an asset whole.  During “normal times” the NCGY is negative by some amount that reflects the normal risk margin for the asset class.  Near the peaks of bull markets, NCGY goes positive.  Think of real estate investors having to feed their properties.  Rents less expenses are less than the mortgage payments.

At the depths of bear markets, both free cash flow yields and funding yields rise considerably, but the FCF yields more so.  Few are investing, because they are looking through the rear view mirror at the past losses.

Eventually, some enterprising sorts that don’t care about convention see the large negative NCGY, and start putting money to work.  The cycle starts to turn, and things begin to normalize, or at least, begin the next cycle.


By believing in limited rationality for men, and recognizing the boom-bust cycle, do I come to the conclusion that Keynes did about animal spirits?  No, I don’t.  Businessmen may follow trends, but enough of them pay attention to the NCGY of their businesses that they know when future opportunities are good or bad.

In that same sense, if our government is trying to get economic behvavior to “normalize,” perhaps it should look at the constraints that businesses/consumers live under, and ask what could be done to change things.  It is not so much a question of animal spirits, as where people find that they have an advantage.

At this point, where so many find themselves hemmed in by debt, demand falls, and the economy suffers.  Perhaps an approach similar to what Barry Ritholtz has proposed would be useful.  Give each household a voucher that can only be applied against debts.  The indebtedness of the private sector will decline.  Their willingness to spend will rise.  Overleveraged households delever; underleveraged households spend more; the US is that much more indebted.

Though it may seem unduly populist, giving money to each household solves two problems: it reduces household debt problems, and it also reduces credit stress at the banks.  What could be better in this environment?