Individual investors tend to be terrible at investing. This is by design. Human brains evolved over millions of years to survive – not to be good at investing. For our ancestors, overweighting every little sign of danger was rational and waiting until things calmed down was necessary for survival. It helped them to avoid being crushed by wooly mammoths or mauled by saber-toothed tigers. The behavioral bias to wait for safety results from millions of years of adaptation.

Yet while this bias was useful for the survival of our ancestors, it turns out to be terribly counterproductive for modern day investing. Robust empirical evidence suggests that bad investor behavior – selling when the world feels ugly and buying when it feels good – may cost investors somewhere between 4% and 8% per year. Humans – in aggregate – collectively become most optimistic or most pessimistic at the least opportune times.

The good news is that we can use these consistently damaging tendencies to our advantage. Because humans inherently respond to fear and greed in the way they do and because these investing tendencies are generally counterproductive to economic success, investor sentiment is universally accepted by practitioners and academics as a contrarian indicator. Still, Wall Street has a vested interest in not promoting this tendency because retail investors imprudently trading on their fear and greed helps drive the profits of Wall Street brokerages.

The more bearish and fearful investors become, the more likely we can expect higher returns in the future. There are many ways to measure the mood of investors and we use a few of the more reliable measures to help gauge the attractiveness of stocks based on investor sentiment. Three of those measures are briefly explained below:

1. AAII Survey Data – The American Association of Individual Investors Sentiment Survey is a weekly survey that has been conducted since 1987. AAII members are asked to predict the direction of the stock market over the next six months as up (bullish), no change (neutral), or down (bearish). Investor sentiment is deemed pessimistic when bearish votes exceed bullish votes.
2. VIX – The CBOE Volatility Index (referred to as the VIX) uses option prices to objectively measure market-implied volatility over the next 30 days. A high level of implied volatility means that investors are fearful and that they perceive higher levels of risk in the future.
3. Put/Call Ratio – The equity put/call ratio is simply a measure of the number of traded equity put options divided by the number of call options. Because put options provide insurance for investors (limiting the downside), a higher level in this ratio reflects fear as it means that investors are buying more portfolio insurance.

Current Sentiment

As it stands right now (June 30, 2022), all three of these sentiment measures reflect abnormally high levels of investor pessimism. This is only the 4^th month-end point over the past two decades where all three of these measures are more than 1 standard deviation above average (to the pessimistic side) at the same time (October 2008, January 2009, February 2020 being the others).

The following chart provides some evidence of the utility of investor sentiment as a contrarian indicator. Following the three prior points when these measures unanimously reflected extreme investor pessimism, the S&P gained an average of 10.8% and 24.7% over the ensuing six and twelve months.

The bottom line is that it is generally unproductive to sell stocks at points like today when sentiment is extremely bearish – when things seem the scariest and the future feels most grim.