5. Human Error and Behavioral Finance

What is human error? Human error means that something has been done that was “not intended by the actor; not desired by a set of rules or an external observer; or that led the task or system outside its acceptable limits”. In short, it is a deviation from intention, expectation, or desirability. Logically, human actions can fail to achieve their goal in two different ways: the actions can go as planned, but the plan can be inadequate, leading to mistakes; or the plan can be satisfactory, but the performance can be deficient, leading to slips and lapses. However, a mere failure is not an error if there had been no plan to accomplish anything in particular.

Behavioral finance has changed the way we fundamentally view the investor. It has effectively challenged the rational expectations model of neoclassical economics. The theory asserts that people are not walking calculators, seeking optimality at every given point, but rather they are emotional decision-makers that are often lazy, rushed, or pressured, and therefore seemed doomed to repeat the same errors over and over. Behavioral finance holds that investors tend to fall into predictable patterns of destructive behavior. In other words, they make the same mistakes repeatedly. Specifically, many investors damage their portfolios by under-diversifying; trading frequently; following the herd; favoring the familiar (domestic stocks, company stock, and glamour stocks); selling winning positions and holding on to losing positions (disposition effect); and succumbing to optimism, short-term thinking, and overconfidence (self-attribution bias).