How the Fear and Greed Index Can Guide Your Investing
CNN's Investor Barometer Can Reveal Prime Buying Times
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:
- 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.
- Market Momentum: How far is the S&P 500 above or below its 125-day average?
- Junk Bond Demand: Are investors pursuing higher risk strategies?
- Safe Haven Demand: Are investors rotating into stocks from the relative safety of bonds?
- Stock Price Strength: What is the tally of stocks hitting 52-week highs as compared to those at one-year lows?
- Market Volatility: Here CNN employs the Chicago Board Options Exchange’s Volatility Index (VIX), concentrating on a 50-day moving average.
- 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.
Use it to determine the best time to enter the market.
Time your investment entry point for when the index dips toward fear.
Watch for companies that are undervalued.
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 as it encourages a market timing strategy rather than a buy and hold strategy.
While it's true that most investors should avoid trying to time the market to score short term gains, the index may be helpful in deciding when to enter the market. 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; he wants to buy them when they are 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."
The Fear and Greed Index becomes a bellwether for when fear is at its peak, and irrational anxiety guides the actions of otherwise reasonable investors.
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.
Behavioral Finance and the Fear and Greed Index
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, depending on whether a decision seems more likely to lead to a gain or a loss. Since we generally prefer to avoid a loss (we're "loss averse"), we will accept more risk to avoid a loss then we will to realize a gain. This behavior predominates when the Fear and Greed Index tilts toward fear.