Many mistakes that investors make are the result of overconfidence. According to researchers David Dunning and Justin Kruger, stupid people overestimate themselves because they don’t know what they don’t know.
It didn’t take long to find the culprit of the bank robbery that took place on 19 April 1995 in Pittsburgh, Pennsylvania: the 44-year-old McArthur Wheeler had not worn a mask and had been filmed by surveillance cameras. The images made the TV news, and Wheeler was arrested less than an hour later. Confronted with the videos, the robber muttered in bewilderment, “But I wore the juice!” He was fully convinced that his face, which he had rubbed with lemon juice, had been invisible to the cameras.
The failed robbery is the point of departure used in a scientific paper published in 1999 that initially received little attention. The paper was written by David Dunning, a professor of social psychology at Cornell University, together with his colleague Justin Kruger. It argues that difficulties in recognizing one’s own incompetence often lead to an inflated self-assessment. Or more specifically: that people with certain weaknesses – for example relating to reading, driving or chess – tend to OVERestimate their own ability while UNDERestimating that of others.
Dunning describes this “Dunning-Kruger effect”, as the phenomenon is known today, as follows: “If you’re incompetent, you can’t know you’re incompetent. The skills you need to produce a right answer are exactly the skills you need to recognize what a right answer is. We are not that great at knowing what we don’t know.” Or as Monty Python’s John Cleese, a friend of Dunning’s, put it in a bitterly dry monolog, “I think the problem with people like this is that they are so stupid that they have no idea how stupid they are.”
The Dunning-Kruger effect is, however, contested. Recent research criticizes the two authors for handling the underlying data carelessly. Dunning critics have also found that better-educated people assess their own abilities somewhat better than the average of the population. However, in their 2017 study, Edward Nuhfer and Steven Fleisher of California State University explain that there is a simple explanation for this: specialists are experienced at becoming aware of the limits of their knowledge: “Self-assessment appears to be an important metacognitive skill that can be learned (and measured). It is possibly one of the most worthwhile skills students can develop.”
Dunning forged ahead with his research, regardless of the criticism. In early 2018, he and his colleague Carmen Sanchez proved that semi-beginners, in particular, tend to overestimate themselves. According to the study, beginners initially approach a task with great respect because they know that they still lack the necessary knowledge. After gaining initial – still modest – experience, however, they quickly fall victim to a “beginner’s bubble” and lose their grip on reality. It is only with growing competence that this self-aggrandizement diminishes again, and the gap between real and imagined ability closes. Initial beginner skills can therefore be fatal. Sanchez and Dunning quote a poem by Alexander Pope to make their point: “A little learning is a dangerous thing.” Beginners are well aware of their shortcomings. A little learning, however, quickly leads them to believe that they know much, if not all, there is to know. According to Sanchez and Dunning, an initial bit of knowledge is therefore a dangerous thing for people who have the tendency to overestimate themselves.
Sanchez and Dunning came to this conclusion based in part on data from the National Financial Capability Survey, a large-scale study that examines the financial literacy of 25 000 Americans over a period of numerous years. The survey shows that the youngest respondents correctly considered their knowledge of investments or retirement plans to still be very incomplete. Young adults between the ages of 25 and 34, on the other hand, who had acquired initial financial knowledge, considered themselves to be on their way to becoming professional bankers.
Anyone who wants to become proficient in a specific area therefore faces a dilemma. On the one hand, learning is necessary to acquire skills. On the other hand, that very learning leads, at least for a time, to overestimating those initial skills. The solution? Dunning and his colleague recommend humility, a path explored by the British philosopher R. G. Collingwood. Collingwood observed that people only become masters of what they specialize in when they learn that they will remain beginners all their lives. This nugget of wisdom is something investors can also learn from.
This article has originally been published on the LGT finance blog (German only)
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