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How Your Inner Freud Can Make You Rich

Understanding the psychology behind investing can keep you on the right path.

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.

The lesson:

Investors latch on to, or "anchor" on, meaningless, irrational or inadequate data to formulate decisions. For example, in May, an investor might have read that the S&P 500 Energy Index was up nearly 180% over the prior four years. He might have felt that energy stocks would keep rising and changed his investing strategy as a result. That index, however, has fallen more than 45% in the five months through Oct. 24.

The solution:

There's a tremendous amount of data available on any investment. It's important to use as much as possible, rather than getting carried away with one number or source. Look at investments from many perspectives, and set goals and strategies for the long term.

Mistake No. 2: overconfidence

In 2006, behavioral economist James Montier asked 300 fund managers about their job performance. Nearly three-quarters said they were above-average, and most of the rest said they were average. Of course, only 50% could be average or above.

The lesson:

Investors tend to put a lot of weight into what they

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know, inflating the importance of sketchy bits of information while ignoring the big picture. For example, an investor might hear about a firm's upcoming launch of a hot product, and buy the stock without considering questions such as, "Is the new product priced into the stock?" "Does the competition have a similar product that could outsell the first one?" "Is the industry poised for a major downturn?"

The solution:

Consciously consider what's missing from your understanding of a particular investing scenario. Then dig deeper, being sure to seek out information that defies your expectations.

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.

Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.