How Your Inner Freud Can Make You Rich

Financial planners often advise keeping emotion out of investment decisions. It's good advice, especially in times like these. Problem is, we humans are hard-wired to do just the opposite.

Over the past 30 years or so, behavioral economists have studied the nexus between economics and psychology, using scientific research to understand investor behavior. There have been many lengthy books on the subject, but the bottom line is fairly simple: While traditional economics assumes that investors are rational, behavioral economics suggests otherwise. Investors have tendencies and mental blind spots that can lead to mistakes, such as buying stocks without complete research, holding on to stocks too long and building portfolios that are overly safe or overly risky.

"We're pretty good at making rational, consistent, self-interested decisions about many issues in life," says Thomas Gilovich, co-author of the first layman's book on the subject, Why Smart People Make Big Money Mistakes. But when it comes to financial matters, "a number of faulty mental habits lead us astray and cost us dearly."

The good news is that by understanding these tendencies, investors can override them and avoid costly mistakes. Here's a look at some of the bedrock findings of behavioral finance.

Mistake No. 1: anchoring

MIT professor Dan Ariely recently asked his students to write down the last two digits of their Social Security numbers, then asked if they would bid that amount of dollars on a series of items. Afterward, he compared the students' bids to their Social Security numbers, and found that students with higher digits placed significantly higher bids.