The Dunning-Kruger Effect (in investing (and life)
The Dunning-Kruger Effect is a cognitive bias first quantified by psychologists David Dunning and Justin Kruger in their 1999 paper “Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments.” Their study demonstrated something we all know to be true from experience: people with low levels of knowledge, skill, or competence tend to overestimate their own abilities. This seminal work led to a wave of similar studies in various domains and has assumed popular cachet as a pseudo-scientific explanation for any number of spectacles and as a source of endless comedy.
Dunning and Kruger’s analysis also demonstrated the converse phenomenon, known as “imposter syndrome,” whereby individuals with actual demonstrated skills tend to underestimate their abilities; however, this part of their original findings hasn’t gained the same cultural following as the first. Their work has important implications for the world of investing and personal finance, as well as the human experience more broadly. However, their original findings have become muddled in the popular cultures’ appropriation of their work.
The Misnamed Dunning-Kruger Curve:
On the internet and in numerous airport business books, the Dunning-Kruger Effect has become closely associated with the chart below, demonstrating the relationship between experience and confidence. Nevermind the fact that this curve never appeared in Dunning and Kruger’s paper (and neither does their data actually support it!), variations of it have become closely associated with their work for the chart’s “truthiness” (a term coined by Stephen Colbert of the Colbert Report, which means something that “feels” true). I can certainly relate to it.
The popularly represented (yet apocryphal) Dunning-Kruger Curve
In this presentation, the journey toward mastery starts with the ascent up Mt. Stuipd. Those who reside at its peak are prone to the most comical (or tragic) errors. They “know enough to be dangerous,” and they think they know it all. With additional experience, most of these overconfident and unaware newbies will learn that there’s far more than meets the eye, and faced with embarrassments and failures will fall into the “valley of despair.” If they stick with it, they’ll begin the long, arduous journey up the slope of enlightenment toward mastery. Along the way, they are ascending the hierarchy of competence (to borrow from another trope). Eventually, their insights run out or their mental or physical faculties decline and it’s time to retire, become a pundit or join senior management!
Note to the Hierarchy of Competence: While there may be some broad parallels between this pyramid and becoming a good investor, never forget that you can have the right analysis and the right intuition, and yet still lose money in the market. “Markets may remain irrational for longer than you can remain solvent!”
Five Musings on the Dunning-Kruger Curve for Investing and Life
These have broad implications for personal finance and investing and raise broader questions about the human experience more generally.
We are all prone to overconfidence and have significant blind spots.
We all camp out at the peak of Mount Stupid. We think that because we read an article in the Economist or because we listen to NPR (or maybe we saw it on Facebook), we are “in the know” about some subject and, therefore, have the right to opine or malign. We even subconsciously erect guardrails to protect us from any information contrary to our assumed viewpoint (a.k.a confirmation bias)! Hindsight biases and confirmation biases run rampant in the world of investing (even among so-called professionals). When you put a herd of these investors together, it’s a wonder we don't see more asset bubbles and flash crashes.
When we have been humbled by experience or convicted of our ignorance, we rarely make it out of the valley of despair.
Struggling with a lack of confidence and faced with what seems like an insurmountable pathway to mastery, most of us will just give up or move on. I’ve left a long trail of abandoned hobbies behind me after a period of initial infatuation and rapid progress that led me to hit a wall and despair about my lack of skill and the costs of overcoming it. Investors who have been burned are prone to throwing in the towel and “going to cash,” getting “whipsawed” by buying high and selling low.
We can occupy different points of the curve at the same time.
We may be subject matter experts in one regard, but in other areas, we are overconfident amateurs, stuck in the valley of despair, or just plain ignorant. This can be true in the business and financial world and life. You may have had a good insight in the past or have some expertise in one area, but if you’ve been investing long enough, you’ll increasingly realize there is so much more that you don't know and cannot possibly anticipate.
Mastery doesn’t mean you’ve made it.
This observation is twofold: the first is practical, and the second is humbling. Look at the “greats” and the “G.O.A.T.S.” among us; you will see that they never graduate from the basics. Think of the guitar virtuoso who returns to the same scales and exercises day after day or Steph Curry working through dribbling exercises and practicing bounce passes before every game. Mastery is a journey, not a destination; the fundamentals are always fundamental. Now for the second observation: so you’ve made it to the “plateau of productivity,” the peak of your game, the pinnacle of your career: congratulations, it’s all downhill from here. Yet, there’s so much more to life than mastery in a particular arena.
Mastery and success don't always go hand in hand.
I love this quote in jest from Mark Twain’s notebook: “All you need in this life is ignorance and confidence, and then Success is sure.” There are many cases where an investor’s dumb luck or an entrepreneur’s unbridled drivenness has resulted in wild financial success. However, there are many more situations where the same combination of ignorance and confidence has led to ruin (and led those who were once the lucky fortunate to lose their fortunes). Practicing discipline, humility, and intellectual honesty, whether concerning investing or generally, comes with no guarantees. But the odds are in your favor, and you’ll have the best chance of avoiding the big mistakes.
Stray thoughts:
The Actual Dunning-Kruger Curve:
Note in Figure 4 that the poorest performers think they are above average. Psychologists call this “illusory superiority”, and the popular press dubs it “the Lake Wobegon effect;” “where all the women are strong, all the men are good-looking, and all the children are above average” (Garrison Keillor). Note also that the top performers underestimate their ability in what may be imposter syndrome or excess humility.
Critiques of the Dunning & Kruger’s Methodology
For further critiques of the Dunning-Kruger effect and how it has been misinterpreted in popular culture and academic circles alike:
The Dunning-Kruger Effect Isn't What You Think It Is - Scientific American
Why the Dunning-Kruger Curves You’ve Seen Are Wrong | by Bret Cameron | Curious | Medium
