4/1/2024

How does emotional neutrality work?

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Trading and investing is always a test of your endurance. After all, instead of succumbing to momentary impulses, it is necessary to conduct a thorough analysis of all factors influencing the financial situation and choose a strategy based on rational considerations.

Emotional neutrality, in the context of trading psychology, is an approach aimed at eliminating the influence of human emotions, such as greed and fear, from the decision-making process.

Emotional neutrality allows you to maximize your chances of choosing the optimal course of action, so we’ll talk about this concept in more detail.

The role of emotions in investing

The efficient market hypothesis postulates that all available information regarding securities is taken into account by investors when making decisions related to them. According to this hypothesis, investors behave rationally without being influenced by emotions, and therefore their actions as a group accurately reflect the available information that should determine prices in the market.

Some researchers believe that investors’ emotions also play a role, which can distort investment decisions and cause markets to deviate from ideal efficiency.

The concept of emotional neutrality is based on the typical human reaction to profits and losses: investors typically feel satisfied when their transactions are profitable and dissatisfied when they suffer losses. Proponents of emotional neutrality argue that if investors can eliminate the influence of their emotions from trading decisions, this will lead to improved trading results.

However, this theory assumes that financial players, aware of their preferences and constraints, are able to make rational decisions, effectively weighing the costs and benefits of each option available to them.

An example of emotional neutrality

Let’s say Company A’s shares have underperformed over the past six months. The company’s revenues are declining and analysts covering the company have mixed opinions. The number of short positions in the stock increased sharply, causing a negative reaction in the media. As a result, the company’s share price fell by more than 10%. However, A is a leader in a promising industry with bright prospects for the future.

An emotional investor may become nervous about stock A’s decline. He may interpret the downward trajectory and negative news as a signal to sell. At the same time, an analyst who adheres to the principle of emotional neutrality is able to objectively assess the situation on the market, weighing all the pros and cons of owning shares A.

He can, for example, analyze the time frame and the feasibility of long-term investments in A. It is also worth reading the news in more detail and understanding the reasons for the fall in the share price. The decline could simply be a healthy correction, or it could be due to temporary regulatory restrictions that may be lifted in the future.

The influence of greed and fear in trading

Many people have a desire to get rich quick, and bull markets feed that desire. A striking example is the Internet boom of the late 1990s and the resulting dot-com crisis.

During times like these, it’s especially important to keep a level head and follow the fundamentals of smart investing, namely taking a long-term view and practicing dollar-cost averaging.

Just as greed dominates the market during a boom, fear dominates the market after a recession. In an effort to minimize losses, investors are rushing to sell shares and shift to more reliable assets.

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