How Your Inner Freud Can Make You Rich

Mistake No. 3: mental accounting

Richard Thaler of the University of Chicago often asks subjects whether they'd walk 10 blocks to save $25 on an item that cost $50, and then whether they would do the same to save $25 on a $1,500 item. He's found that 75% would walk to get the deal on the $50, but only 20% would do so for the higher-priced item. This "mental accounting" is irrational, he says, because the money saved in both cases is exactly the same -- $25.

The lesson: Investors treat different amounts of money differently. For example, you might buy something using "found" money. Some investors even break down their investments into safe and speculative portfolios to keep negative returns from the latter from affecting the former.

The solution: Remember, all money is the same. When it comes to investing, consider a portfolio as one entity, regardless of the number of accounts, and make decisions based on the whole picture.

Mistake No. 4: excessive fear of losses

Princeton's Daniel Kahneman and Amos Tversky found that individuals are much more distressed by prospective losses than they are happy about equivalent gains. Other researchers found that investors view a $1 loss twice as painful as the pleasure they'd earn from a $1 gain.

The lesson: Investors tend to stick with bad investments to avoid selling at a loss, and even invest more in a loser in order to "win back" lost funds.

The solution: Pay more attention to what a stock is likely to do in the future than what it cost in the past. Review all investments at least once a year to build and maintain a portfolio that meets your long-term goals, time horizon and risk tolerance.