Are Financial Decisions Actually Made by Animal Spirits?
On Emotions in Financial Markets
Economics. A world where every decision is perfectly rational, every dollar spent with careful calculation, and every choice optimized for maximum benefit. In this world, people meticulously weigh the pros and cons, ensuring that no decision disrupts the delicate balance of supply and demand. The result? A flawless equilibrium, where markets function in perfect harmony—thanks to the ever-rational homo economicus (not my term, by the way).
Well… that’s a nice theory.
Reality? Not so much. Humans are anything but rational. We take shortcuts, rely on gut feelings, and make hasty calculations (if we even bother doing the math at all). In fact, if aliens were to analyze us, I doubt “rational” would even crack their top 10 descriptors for human behavior—I’ll confirm if I ever get the chance. The truth is, economists don’t actually believe people are perfectly logical decision-makers. Rationality is just an assumption—a simplification that makes economic models workable. But here’s the problem: when you repeat an assumption long enough, people start to mistake it for reality. Most investors, for example, don’t even realize that the economic models they rely on are built on this very premise.
So, what happens when we drop this assumption?
Chaos. Markets don’t behave like neat equations because humans don’t behave like robots. We’re driven by instincts, emotions, and cognitive biases—things that are nearly impossible to quantify. But that doesn’t mean emotions have always been ignored in economics. The legendary economist John Maynard Keynes was one of the first to acknowledge them, coining the term animal spirits to describe the instincts and emotions that drive human behavior. While this wasn’t the foundation of Keynesian economics—his primary focus was on government intervention to stabilize economies—it was a crucial insight into why markets don’t always function as efficiently as classical economists assumed. In his seminal work The General Theory of Employment, Interest, and Money, Keynes highlighted how these animal spirits influence financial decisions in ways pure logic never could.
The cartoon below illustrates this concept perfectly:
Of course, it’s exaggerated for effect. But the growing field of behavioral economics has been proving for years that emotions play a crucial role in financial decisions. Ignoring them means ignoring a major force that shapes markets, investments, and economic cycles.
That’s why today, I want to take you on a deep dive into this topic. I recently finished Animal Spirits by Akerlof and Shiller, where they explore five key psychological forces that drive economic decisions. I’ll be sharing those insights with you—and trust me, you’ll likely recognize yourself in at least one of these behaviors.
So grab a coffee, get comfortable, and let’s explore the real forces shaping our economic world.
Five Animal Spirits
Confidence
Confidence—especially the confidence multiplier—is a powerful force in the economy. Think of it like a domino effect: once set in motion, it fuels itself in a loop of growth or decline. This concept is reflected in Fear & Greed indexes used in crypto, which measure how optimistic or anxious investors, consumers, and financial institutions feel about the future—not based on hard data, but on perception.
This ties closely to Keynes, who introduced the concept of a multiplier. Let me break it down. Keynes defined the marginal propensity to consume (MPC)—essentially, the fraction of each additional dollar of income that people spend rather than save. For example, an MPC of 0.5 means that for every extra dollar earned, 50 cents is spent and 50 cents is saved. Keynes argued that government spending could leverage this effect to stimulate the economy. Say the government injects $100 million into the economy through wages for a public project. The workers who receive that money spend half of it—$50 million—on goods and services. The businesses that receive this money then pay their own workers, who also spend half, and so on. This cycle means that a single dollar of government spending generates more than a dollar of total economic activity—a multiplier effect.
Confidence works in a similar way, but here’s the key: it’s driven by perception, not rational analysis. When people believe the economy is strong, they spend more, assuming future prosperity. This spending fuels businesses, which then expand, hire more workers, and reinforce the belief that good times are ahead. The cycle continues, driven not necessarily by data, but by collective sentiment. But the reverse is just as powerful—when confidence drops, people cut back on spending, expecting downturns, which in turn slows businesses, reduces hiring, and makes the pessimism self-fulfilling.
The same applies to credit. When financial institutions feel optimistic, they lend more freely, triggering investment and growth. But if uncertainty creeps in, lending dries up, businesses hold back on expansion, and the economy slows—not because of any fundamental collapse, but because people expect it to.
Clearly, confidence spreads through the economy like wildfire—capable of sparking either a boom or a crisis, not based on logic, but on belief alone.
Fairness
Fairness. It’s wired into us. And where does this instinct show up most? That’s right—our jobs.
In a “rational” economy, labor is just another resource, like steel or corn. Simple supply and demand should dictate wages: when demand for workers is high, wages go up; when the labor supply is high, wages drop. The market finds its equilibrium, and—at least in theory—there should be no such thing as involuntary unemployment. If you can’t find a job, just lower your wage expectations until someone hires you.
Sounds neat. Too bad reality doesn’t work that way.
People don’t see themselves as mere commodities. We expect fair pay for our work. If two people with the same job and skills in the same area are earning different wages, it feels wrong. And that feeling matters—a lot. We have an internal idea of our own “worth,” and we’re not willing to work for just anything. Plus, laws like minimum wage set a legal floor, reinforcing that wages aren’t purely market-driven. This is why involuntary unemployment does exist—if the only available jobs pay less than what people consider fair (or legally acceptable), they won’t take them.
This is where efficiency wage theory steps in. Unlike classical economics, it recognizes that hiring someone isn’t just a one-time transaction—it’s an ongoing relationship. Employers don’t just want warm bodies; they want motivated, productive employees. And one way to get that? Paying a little more than the market rate. Higher wages create loyalty, reduce turnover, and encourage employees to work harder. In a way, employers see this as a fair trade—better performance in exchange for better pay.
Fairness also explains why people rarely quit their jobs during recessions. Even if their job isn’t perfect, they feel lucky to have one when others are struggling. Walking away wouldn’t just be risky—it would feel ungrateful.
So, whether it’s about pay, loyalty, or motivation, fairness is a powerful force shaping the labor market. Another prime example of an animal spirit at work.
Corruption
Corruption. Easily the strangest animal spirit on this list. It’s not exactly an emotion, but it is a force that creeps into the economy, slowly growing beneath the surface until—boom—it’s too big to ignore. By the time it reaches critical mass, the damage is already done. And more often than not, corruption plays a major role in setting the stage for economic crises.
Take the Enron scandal in 2001. If you’re too young to remember (same here), here’s the short version: Enron, once a massive energy company, got caught faking profits for years using “creative accounting.” When the truth came out, their stock price collapsed, their executives faced prison, and their accounting firm—one of the biggest at the time—was also taken down for enabling the fraud. The scandal rocked the economy and destroyed trust in corporate financial reporting. And, believe it or not, Enron is somehow back, claiming to have “reinvented” itself—oh, and they even launched a cryptocurrency. Because, of course, they did.
Then there’s the Great Financial Crisis (GFC) of 2008, a prime example of corruption triggering economic catastrophe. I won’t go into every detail (that’s an article for another day—hint hint), but one of the biggest players in this mess? Credit rating agencies. Their job is to assess the risk of financial securities, slapping them with familiar ratings like AAA (top-tier, ultra-safe) down to D (don’t touch this with a ten-foot pole). The three main agencies—Standard & Poor’s (yes, the S&P 500 people), Moody’s, and Fitch—all had one job: to warn investors about risky assets.
But here’s where the corruption kicked in. Mortgage-backed securities (CDOs) were given glowing AAA ratings, despite being stuffed with subprime loans that were bound to fail. And when asked why they did this after the financial system collapsed, their answer was blunt: “If we didn’t, the banks would’ve just gone to another rating agency.” In other words, they prioritized profits over truth, and the entire system came crashing down because of it.
That’s how corruption works. It creeps in quietly, slowly distorting incentives, eroding trust, and inflating bubbles—until one day, it bursts in spectacular fashion, taking the economy down with it.
Never underestimate this animal spirit. It has a nasty habit of showing up right before everything falls apart.
Money Illusion
Money illusion. We all fall for it. Instead of thinking in real terms, where inflation is factored in, we focus on the numbers we see—nominal terms. But here’s the reality: if you get a 4% raise while inflation is at 5%, you didn’t actually get a raise. In real terms, your purchasing power just dropped by 1%. Congratulations, you got a negative raise.
For years, inflation was low enough that people didn’t pay much attention to it. Sure, it still mattered, but it wasn’t a major concern. Fast forward to the last two years, and inflation has been anything but ignorable—persistent, high, and sticky. Yet, despite its impact, we still struggle to think in real terms.
Investors are guilty of this all the time. A 10% nominal return sounds fantastic, but if inflation is 3%, the real return is only 7%. Do people mention this? Hardly. (I’ll admit, I’ve been guilty of this too.) We’re wired to think in raw numbers, even when those numbers don’t tell the full story. The same logic applies to wages.
In Belgium, wage negotiations are relatively structured, with most sectors automatically adjusting wages for inflation. Sounds great, right? Well, kind of. There’s a catch: wage indexation only happens after inflation crosses a certain threshold, meaning adjustments are always based on past inflation, not future expectations. And that’s better than what happens in most countries, where getting wages to automatically adjust for inflation is like trying to move a brick wall.
Take Canada, for example. A study covering 1976 to 2000 (yes, it’s old, but bear with me) found that only 19% of wage negotiations included automatic inflation adjustments. And when they did, it was almost always tied to past inflation rather than future expectations.
Despite what economic models assume, people don’t naturally account for inflation. Money illusion is deeply ingrained in us—it’s just how our brains work. And that little blind spot? It shapes everything from investments to wages to economic policy.
Stories
Stories. Our brains are wired for them. Back in the caveman days, stories weren’t just entertainment—they were survival tools, passing down knowledge about which berries won’t kill you and which paths not to take at night. They stick with us because they’re filled with emotion, making them much easier to process than pure logic.
And because storytelling is so deeply ingrained in us, it’s everywhere—including the economy. Stories shape confidence. A compelling narrative can fuel optimism, and optimism fuels action. But here’s the catch: we don’t just experience events and then tell stories about them. We reverse-engineer the story to fit what already happened. We don’t ask, Does this event fit the story? Instead, we tweak the story until it explains what we’ve seen.
Nassim Taleb calls this the narrative fallacy in Fooled by Randomness, and it’s something humans fall for all the time. Take AI, for example. I know, I know—you’ve probably heard this comparison a hundred times by now, but stick with me. Let’s rewind to the dotcom bubble of the late ‘90s.
When the internet started gaining traction, investors lost their minds. “The internet will change everything!” they said. And sure, in hindsight, they were right. The internet did revolutionize the world. But at the time, no one actually knew how it would play out. Least of all the investors throwing cash at anything with “WWW” in its name. Logic took a backseat to the story—the dream of an internet-powered future. Stock prices soared. And when investors saw prices soaring, they took that as proof they were right: “See? The market agrees!” More confidence led to more investment, which led to higher prices, which led to even more confidence.
Until it didn’t.
Then the story flipped, and so did the returns. Boom. Crash.
Now, am I saying AI is a scam? Not at all. Just like the internet, AI is undoubtedly a revolutionary technology. The real question is: how revolutionary? And the truth is, no one really knows yet. But that hasn’t stopped people from spinning stories about it. And, just like before, some of those stories have a thick layer of snake oil on top.
That’s why stories might be the strongest animal spirit of them all. We can’t turn this feature off—it’s part of being human. It has always shaped the way we see the world. And it always will.
The Implications
I can see this article is already getting pretty long—though, let’s be honest, when have we ever managed to keep a Friday article short? So, let’s wrap it up.
First, from a macroeconomic perspective, it’s clear that the whole homo economicus assumption—the idea that humans are perfectly rational decision-makers—isn’t just slightly wrong. It’s wildly wrong. We’re emotional creatures, and those emotions shape economic conditions in ways traditional models often ignore.
So, does that mean we should throw out all economic models and start from scratch? No, that would be throwing the baby out with the bathwater. Economics is already a tricky field, with an endless number of unpredictable factors at play. Assuming rationality helps simplify things, allowing economists to focus on quantifiable elements. It’s a solid foundation. But we need extended models—ones that account for animal spirits and the actual ways humans behave. Would this be incredibly difficult? Absolutely. And predicting how aggregate human behavior will fuel the next boom or bust? Nearly impossible. But worth trying, at the very least.
Second, on a personal level, don’t assume you’re immune to irrationality. Even if you know these biases exist, you can’t fully eliminate them. Recognizing them is step one—but then what? Honestly, I don’t have a perfect answer. And I probably won’t anytime soon. It’s a constant learning process, one that evolves alongside changing economic conditions. But that’s fine by me—I like a challenge. And if I ever figure it out, you can bet I’ll write about it here.
Speaking of which, next week, we’re kicking off a fresh analysis on our latest winner: Aris Water Solutions. How did we land on this company, you ask? Well, the answer’s right here—check it out!
This Sunday, we’re analyzing whether Small Caps are a strong investment opportunity again.
Hope you enjoyed this deep dive into animal spirits, and I’ll see you next time!
📢 What do you think? Do you see animal spirits at play in today’s markets? Have you ever caught yourself falling for one? Drop your thoughts in the comments—I’d love to hear your take! 👇
🔔 Don’t miss out! This Sunday, we’re diving into the financials of Aris Water Solutions—breaking down the numbers and what they really mean. Stay tuned!
