Emotional Neutrality

What Is 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 the psychological influence of 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.

Understanding Emotional Neutrality

The efficient market hypothesis assumes that investors incorporate all information relevant to a stock while making decisions related to it. Under the efficient markets hypothesis, it is assumed that investors are rational and unmoved by emotions and, hence, as a group make decisions that accurately reflect the available information that should determine market prices.

Some researchers have argued that investor emotions also play a role, which may bias investing decisions and influence markets away from perfect efficiency. For example, noted economist Robert Shiller stated in his book Irrational Exuberance that one of the factors responsible for the upswing in tech stocks during the dot com bubble at the turn of the millennium was investors' emotional state.

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, 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. Researchers in behavioral economics and finance often dispute that this is the case, even absent emotional influences, due to various cognitive biases. Behavioral economists, drawing on psychology and economics, contend that humans are not rational and are incapable of making good decisions.

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 that the downfalls and risks of the company's stock are overblown, thus leading to attractive buying 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 about hyped stocks can have the opposite effect.

Example of Emotional Neutrality

Suppose that the stock of ABC, Inc. has not been performing well for the last six months or so. Its earnings have been in decline and the consensus view of a majority of analysts covering it is mixed. Shorts against the stock have ballooned as has negative press. The overall effect of this negativity is that ABC's stock price has crashed by more than 10% during this time period. But ABC is a leader in a nascent industry that has bright future prospects.

An emotion-driven investor with holdings in ABC might become jittery with the stock's decline. He might look at ABC's downward trajectory and negative news as signs that it is time for a sale.

An emotionally neutral investor, however, might look at the overall market and evaluate the pros and cons of holding the stock.

For example, he might consider the timeframes involved and whether it makes sense to make a further investment in ABC for the long term. He might also look at news reports and analyze the root cause of a fall in ABC's price. The price decline might simply be a healthy correction in ABC's stock. Or, it might be due to regulatory bottlenecks that are expected to ease in the future. Either way, the emotionally neutral investor will base his decision on available facts, instead of following the herd.