DEFINITION of 'Emotional Neutrality'

Emotional neutrality is the concept of removing greed, fear and other human emotions from financial or investment decisions. The goal of emotional neutrality is to remove emotion from the process of making objective financial decisions, so that the best possible decision can be made, regardless of whatever emotions those decisions may trigger.

BREAKING DOWN 'Emotional Neutrality'

The concept of emotional neutrality arises out of the typical human reaction to profits and losses — investors are typically pleased when their trades produce profits and unhappy when their trades produce losses. If investors are able to remove the impact that their emotions have on their trading decisions, proponents of emotional neutrality contend that doing so will result in improved trading performance. However, in behavioral economics, this theory assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them.

Emotional Neutrality Applications

Taking things one step further, some investors adopt what is called a contrarian strategy, in which they attempt to buy securities when everyone else is selling them, and sell securities when everyone else is buying them. The rationale behind this strategy is that if investors are not emotionally neutral, their emotions will impact their trading decisions and thus under- or over-value securities, creating an opportunity for profit for contrarian traders. When there is an overarching pessimistic sentiment on a stock, it may push the price so low, the downfalls and risks of the company's stock are overblown. This theory contradicts classical economics, where it is assumed that the rational person has self-control and is unmoved by emotions and external factors and, hence, knows what is best for himself. However, behavioral economics, drawing on psychology and economics, explains that humans are not rational and are incapable of making good decisions, thus leading to market opportunities.

Figuring out which distressed stocks to buy and selling them once the company recovers, thus boosting the stock value, is the major play for contrarian investors. This can lead to securities returning gains much higher than usual. However, being too optimistic on hyped stocks can have the opposite effect.

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