The Fear and Greed Index: What Is It, and How it Relates to Market Sentiment

Sun Jul 10 2022

Introduction

Do you ever watch the news and wonder what drives the often bizarre day to day changes in the stock market? The fundamental long term viability of large companies doesn't change so often, so what can be driving it?

The short answer is that the stock market is actually a behavioural tracker that follows market sentiment. A whole host of factors affect whether people feel positively or negatively about the stock market on any given day, and this is reflected in the short term market changes that result. So how can we measure this, and can we use it to our advantage?

Well, the fear and greed index are two important indicators that traders watch to help them determine market sentiment. The fear index is designed to measure how much fear is in the market, while the greed index measures how much greed is in the market. These indexes can be helpful in determining when a market is overbought or oversold. In this blog post, we will discuss what these indexes are and how they relate to market sentiment in the stock market.

What are the fear and greed index, and what do they measure

The fear and greed index are important indicators that traders watch to help them determine market sentiment in the stock market. The fear index is designed to measure how much fear is in the market, while the greed index measures how much greed is in the market. These indexes can be helpful in determining when a market is overbought or oversold. The term was actually coined by CNN, who publishes its own Fear and Greed index.

based on 7 different factors:

  1. Stock Price Breadth
  2. Stock Price Strength
  3. Market Momentum
  4. Junk Bond Demand
  5. Safe Haven Demand
  6. Market Volatility
  7. Put and Call Options

How do fear and greed affect market sentiment

One of the more paradoxical elements of the stock market relates to sentiment: why is it that investors are most optimistic at the top, when prices are high, and most pessimistic at the bottom, when prices are low? A rational long term investor would want to take the opportunity to purchase quality assets for the long term at a discount. You wouldn't get excited if anything else went on sale, would you?

The index is a great way of gathering some idea as to what point in the cycle we are, and whether now may or may not be a good time to invest. Now, investing a set amount each month solves this decision paralysis, and is known as pound (or dollar) cost averaging.

How can investors use fear and greed indexes to their advantage

The fear and greed index can be a helpful tool for investors to gauge market sentiment and make investment decisions. By monitoring the fear and greed index, investors can get an idea of when the market is overbought or oversold. As discussed, this information can help investors decide when to buy or sell stocks.

Is it accurate?

It's generally accepted as an approximate guide to where we are in a cycle. It's not, however, consistent over time as a reading that signals extreme fear today, may have given a neutral signal in the past for example. It also doesn't account for momentum - prices may continue to fall after we reach extreme fear, or continue to rise even after the index reaches extreme greed.

In Conclusion

Fear and greed are two important emotions that drive market sentiment. fear can cause investors to sell their stocks, while greed can cause them to buy more stocks than they should. Both of these emotions can lead to market changes that benefit or harm investors. Given that the index is broadly accurate and takes into account a number of different factors, it's a good sense check. However, it should be used in conjunction with other signals - be these qualitative or quantitative market analyses.

Warren Buffett said that investors should be "greedy when others are fearful, and fearful when others are greedy" - taking a contrarian approach to market movement can be a strong strategy for buying desirable assets with strong fundamentals at discount prices. To track the performance of your portfolio, and to compare your own allocation to Mr Buffetts in-platform, sign up to Strabo today!

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