CNN's Fear and Greed Index Explained

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.



 


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.2 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."

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.4 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.