CNN's Fear and Greed Index (FGI) tracks how investors feel each day, week, month, and year. When there's a lot of fear, stock prices can drop too much, and when there's too much greed, prices can go too high. This index is a useful tool for making smart investment decisions.

7 Different Factors To Score Investor Sentiment

CNN examines seven different factors to give a score indicating how investors feel, ranging from 0 to 100, where 0 represents extreme fear and 100 represents extreme greed.

1. Stock Price Breadth: The Fear and Greed Index (FGI) considers how much trading activity, measured by share volume, has gone up or down on the New York Stock Exchange (NYSE). It uses data from the McClellan Volume Summation Index for this analysis.
2. Market Momentum: How much is the S&P 500 higher or lower than its average over the past 125 days?
3. Junk Bond Demand: Are investors choosing riskier strategies?
4. Safe Haven Demand: Are investors moving from safer bonds to invest in stocks?
5. Stock Price Strength: How many stocks are currently reaching their highest prices in a year versus those at their lowest prices in the past year?
6. Market Volatility: Here, CNN uses the Chicago Board Options Exchange's Volatility Index (VIX) and focuses on a 50-day moving average.
7. Put and Call Options: How much are put options trailing behind call options (indicating greed) or outperforming them (indicating fear)? Put options enable investors to sell stocks at a predetermined price by a specific date, while call options function similarly, but investors use them to buy stocks.

When used correctly, the Fear and Greed Index can help guide you in making profitable investments. Here are some things you should and shouldn't do when using the FGI to assist your investments.

Understanding the Fear and Greed Index

Some critics don't consider the index a reliable investment tool because it promotes a market-timing strategy instead of a buy-and-hold approach.

While it's true that most investors should avoid trying to time the market for short-term gains, the index can be useful in deciding when to enter the market. To do that, you might want to consider timing your investment entry point when the index leans toward fear. This approach mimics billionaire Warren Buffett, who prefers to buy stocks not just when they're low but when they're 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."
(Wiley. "Warren Buffett Quotes.")

The Fear and Greed Index serves as an indicator of when fear is at its peak, influencing the decisions of otherwise rational investors driven by irrational anxiety.

Behavioral Finance and the Fear and Greed Index

While the Fear and Greed Index might seem like a quirky investment measure, there's a solid case for its value. Consider the intriguing research in behavioral finance, where scientists have even studied rats pressing a bar as a proxy for human fear and greed.

A significant moment for behavioral finance occurred in 1979 when psychologists Daniel Kahneman and Amos Tversky introduced "prospect theory." This theory explains how individuals can be both risk-averse and risk-taking, depending on whether a decision appears more likely to result in a gain or a loss. Since we generally prefer to avoid losses (being "loss-averse"), we're willing to take more risk to prevent a loss than to secure a gain. This behavior becomes prominent when the Fear and Greed Index leans toward fear.

Frequently Asked Questions (FAQs)