Investor Emotions and Where to Find Them

Looking for Answers in Moody Markets

Anyone who has watched the stock market for any length of time knows it is subject to two key investor emotions: greed and fear.

For example, in 2008, as the market struggled with a slowing economy, a credit crisis, and the uncertainties created by an important national election, money poured out of stock funds and into money market funds.¹ This pattern is not uncommon during periods of stock price volatility, as investors flee riskier assets in search of potentially safer havens.

Flows in and out of mutual funds are just one of several key ways to help gauge investor sentiment. Other key indicators include the Volatility Index, stock splits, and the Dow’s current dividend yield.

Volatility Index. The Chicago Board Options Exchange publishes this key measure of institutional investor sentiment, which carries the ticker VIX and is frequently referred to as the “investor fear gauge.” This index is based on the implied volatility of S&P 500 index options. Implied volatility reveals the market’s expectations for future price volatility based on the options market. The VIX rises when implied volatility rises.

An old saw advises: “When the VIX is high, it’s time to buy. When the VIX is low, look out below.”² This means that when the VIX is high, usually 50 or above, it may indicate that the market is overly bearish and that sentiment will soon swing back to bullishness.

Stock splits. When a company splits its stock, it may have any number of reasons for doing so, but the most common ones are purely psychological. Companies commonly split their stock when the price becomes too high for individual investors to buy in round lots. A split can be a bullish signal because it means the stock’s price has been rising and the firm is optimistic about attracting new buyers. Therefore, a spike in the number of firms splitting their stock may indicate widespread optimism.

Current dividend yield of the Dow Jones Industrial Average. When the Dow’s current dividend yield rises or falls, it is an indication of how willing people are to own stocks. The more expensive a stock is in relation to the dividend it pays, the lower the yield. A falling yield can mean that people are confident in stocks and are willing to pay a high price to earn dividends. A rising yield can mean that demand for stocks is falling and taking the price down with it.

It would be rare for a shift in investor sentiment to warrant a change in your long-term strategy. However, keeping an eye on investor emotions is a good way to give your own expectations a reality check.

1) Investment Company Institute, 2009
2) Investopedia, 2009

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2010 Emerald.