A few years ago, billionaire Warren Buffett advised investors to "be fearful when others are greedy and greedy when others are fearful." Or at least that's how he's often quoted.

Here's what Buffett really said: "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

It wasn't exactly an argument for letting emotions rule your investments.

The truth, though, is that most of us let emotions drive our investment decisions much of the time. And we generally end up being greedy when everybody else gets greedy and fearful when there is panic on The Street. Video: When markets go wild

Maybe that's just how we're built. One of the most venerable ideas in conventional economics is that investors act rationally, balancing pros and cons to arrive at the best possible decisions based on the available facts. But that's not what we really do, according to researchers in the iconoclastic new field of behavioral economics, which focuses on how the mind-body connection shapes financial decisions. They say most investors are not only irrational but systematically irrational. That is, we make the same stupid mistakes over and over.

This might sound at first like depressing news, if not exactly surprising. Irrational greed caused a lot of us to latch onto the dot-com euphoria in mid-1999. And irrational fear caused us to bail out once we were deep into the 4,000-point plunge in the Dow Jones Industrial Average. The ensuing sense of pain and revulsion about stocks left many of us sidelined in mid-2002. As a result, we also missed the Dow's 5,000-point climb back to the top. Timeline: The worst financial crises

You can find the same dumb, self-defeating pattern -- from greed to panic to revulsion -- in every financial boom and bust through history, from the Japanese property and stock mania of the 1980s to Wall Street's Roaring '20s, or even going back to the South Sea Bubble of 1720 and the Dutch tulip-market madness of the 1630s.

What's new is that we are beginning to recognize this pattern and understand how the quirky nature of the human mind shapes, or misshapes, our investing. And that shouldn't be depressing at all. In fact, this insight can help us avoid making the same mistakes next time.

For instance, we are all susceptible to what behavioral economists call "framing" errors. Presented with the same basic economic proposition, we make markedly different choices depending on whether the deal gets framed in terms of loss or gain. That may sound obscure. But it's probably already cost you big money.

In a market crash, for instance, even the most stalwart investors often get to a point where they give up and punt. "And as soon as they sell," says Smith Barney senior portfolio manager Noah Myers, they "become more rational."

The owner of a portfolio that has taken a big hit will tend to see his stocks only through the framework of loss, Myers explains. But after selling, he can look at the same beaten-down stocks as a buyer and suddenly see tantalizing potential for gain. Myers has seen people dump sizable portfolios and then jump back into the market several weeks later, once stocks have started rising again. And the framing error has caused them to "leave six figures on the table."

We make such elementary mistakes in part because emotional overreactions short-circuit the more complex decision-making machinery of the brain. And it can happen anytime we say "buy" or "sell."

At the Massachusetts Institute of Technology's Sloan School of Management, finance professor Andrew Lo and his fellow researchers wired up professional securities traders in the thick of market action. Sensors measured heart rates, blood volumes, skin conductance, facial muscle movements and other indicators of emotional responses while the traders went about their daily business -- averaging 10 trades a person per day, at $3 million to $5 million per trade. Given their training, experience and financial incentives, these traders ought to have been utterly rational. But the measurements revealed that emotions shadowed every risky decision. Video: Wired for action

Those emotional responses alone weren't necessarily bad, Lo says. He knows good decision-making isn't a contest between reason and emotion but a duet. Rationality actually "requires emotion to motivate us to act in one way or the other."

What Lo found with professional traders, as well as in a follow-up study of day traders, was that the people who reacted too emotionally to gains or losses tended to be lousy investors. Excitement was indeed an enemy, as Buffett suggested. But there was something else at work as well: Those with too little emotion also underperformed.

"There seemed to be a sweet spot somewhere in the middle," Lo says. "Those were the traders that were likely to have done the best." Video: Finding the sweet spot

Research by Lo and other behavioral economists suggests tantalizing possibilities, which will be detailed over the next few segments of this story: As you continue reading, you'll begin to understand the unconscious emotional quirks in your own investing behavior. By employing some of the practical behavioral remedies now being developed, you should

also be able to find the sweet spot that works for you. And here's the goal: Next time you get up to dance with fear and greed . . . you lead. Quiz: How emotional are you?

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Published Jan. 25, 2008