How the Fear and Greed Index Can Guide Your Investing

CNN's Investor Barometer Can Reveal Prime Buying Times

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CNN's Fear and Greed Index (FGI) measures investor emotions of fear and greed on a daily, weekly, monthly, and yearly basis. Too much fear can drive stock prices too low, while greed can raise prices too high. This index can serve as a tool for making sound investments.

7 Different Factors to Score Investor Sentiment

CNN looks at seven different factors to score investor sentiment on a scale of zero to 100—extreme fear to extreme greed respectively:

  1. Stock Price Breadth: How far has share volume advanced or declined on the New York Stock Exchange (NYSE)? Here, the FGI relies on data from the McClellan Volume Summation Index.
  2. Market Momentum: How far is the S&P 500 above or below its 125-day average?
  3. Junk Bond Demand: Are investors pursuing higher risk strategies?
  4. Safe Haven Demand: Are investors rotating into stocks from the relative safety of bonds?
  5. Stock Price Strength: What is the tally of stocks hitting 52-week highs as compared to those at one-year lows?
  1. Market Volatility: Here CNN employs the Chicago Board Options Exchange’s Volatility Index (VIX), concentrating on a 50-day moving average.
  2. Put and Call Options: To what extent do put options lag behind call options—greed—or surpass them—fear? Put options allow investors to sell stocks at an agreed price on or before a specified date, while call options work the same way, only investors are buying stocks.

If used properly, the Fear and Greed Index can be used as a guide for making profitable investments. Here are some do's and don'ts when using the FGI to help you invest.

Do's

  • Use it to determine the best time to enter the market.

  • Time your investment entry point for when the index dips toward fear.

  • When fear is high, watch for companies that are undervalued.

Don'ts

  • Use the index to determine short-term gain.

  • Invest when greed is high.

  • Abandon a stock too quickly before making a profit.

Understanding the Fear and Greed Index

Some skeptics dismiss the index as a sound investment tool. A contributor to the Seeking Alpha website, for example, sees the Fear and Greed Index as a barometer for the market-timing crowd. The blogger, who goes by “JAMM Investing,” makes some good points in that this isn’t a tool for making a quick score: “Going back to mid-2010, a strategy to buy-and-hold, the S&P 500 would have returned 95 percent. A sell-on-greed strategy would have returned only 50 percent or less.”

Yet, that supposes that you’ll use the index for short-term gain when in reality, it can be employed much more effectively to support entering the market at the right time. To do that, you’ll want to consider timing your investment entry point when the index tips toward fear.

In this way, you will be imitating no less an authority than billionaire Warren Buffett, who has famously stated that he doesn’t merely like to buy stocks when they’re low: “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."

Therefore, the Fear and Greed Index becomes a bellwether for when fear is at its peak, and irrational anxiety guides the actions of otherwise collected investors. In addition, if you look at the index, spikes of greed alternate with troughs of fear with rollercoaster precision, and with little moderation in between.

If using the Fear and Greed Index, watch for strong currents of fear, and when they hit, watch for companies that are undervalued. That way, you can uncover some otherwise hidden opportunities for great investment, provided you stay with the stock for the long haul.

While the Fear and Greed Index might sound like a fun investment metric, there’s a strong case to be made for its merit. Consider, for example, the fascinating—and perhaps wacky—research that has gone into the foundations of a related field known as behavioral finance. For example, some scientists have studied how often rats press a bar in hopes of getting a reward as a measure of human fear and greed.

The real turning point for behavioral finance came in 1979, when psychologists Daniel Kahneman and Amos Tversky developed “prospect theory,” which explains how the same person can be both risk averse and risk taking. Their ideas, by the way, helped form the decision-making process depicted in the movie "Moneyball," a true story based on rebuilding the Oakland A's baseball team. 

In a nutshell, fear and greed can drive investment a lot more than you might think—at least when we’re not caught up in those emotions ourselves.

Thought Process for Making Investments

When it comes to investing, people make decisions two ways. The first way is based on mathematical models and statistics, such as the price-to-earnings ratio, which indicates whether a company’s stock is overvalued, undervalued, or priced right. The second way is by going with your gut feeling, similar to how a poker player determines their next move.

Rarely are the two styles mutually exclusive. For example, maybe you researched an SUV purchase by studying price points, performance and ratings in Consumer Reports. Then you found the one with heated seats, and brought out your checkbook. The same sort of logic applies to stocks, and the motivations behind why people purchase them.

Sadly, much fear and greed stems from a lack of planning and education. And in that way, investment isn’t all that different from other avenues of life. By way of analogy, somewhere between gorging and starving one’s self, eating junk and overdoing restraint, lies a happy medium informed by sound dietary principles learned and practiced over the course of a lifetime.