In the field of psychology, the Dunning-Kruger effect is a cognitive bias (a person’s distorted reality) in which people with low ability overestimate their ability and underestimate those with higher abilities.
The effect is to create a wide gap between what the person perceives is the difference between their skill level and the skill levels of others.
People suffering from the Dunning-Kruger effect often make fools of themselves.
They go on singing competitions and embarrass themselves, then rant and rave in the ensuing interview about how others with inferior talent were able to pass on to the next level but they didn’t.
Singing competitions are classic examples of the Dunning-Kruger effect.
In a room full of singers, each individual will rate themselves better than average. Otherwise, they wouldn’t be there.
Do you see the impossibility of that situation?
If everybody was above average, then the average wouldn’t be the average. In other words, we can’t all be better than average. The truth is many investors are overestimating their abilities.
Even in areas where individuals have some competence, they often estimate their skills as higher than they are because they don’t know what they don’t know. It’s those who are the most competent who are more likely to recognize their deficiencies. The incompetent don’t know enough to know what constitutes a deficiency so they wouldn’t know how to recognize the shortcomings in themselves.
The more competent we are, the more we realize what we don’t know.
Charles Darwin summed it up best when he said, “ignorance more frequently begets confidence than does knowledge.”
Nowhere is the Dunning-Kruger effect more pervasive than with investing – especially in the stock market. Everybody thinks they can do better than the average. This overconfidence makes people fail to see their deficiencies and often results in bad decisions.
Like the overconfident singer that makes a fool of themselves on American Idol, the overconfident investor often suffers significant losses because of their biases.
Here are typical mistakes of overconfident investors:
- They hold losing investments for too long. It’s difficult for overconfident investors to admit that they made a mistake. Having to sell a losing investment would result in having to admit that they made a mistake.
- They sell winners too soon. They think they know better than the rest market and sell winners early because they believe they’ve maxed returns and nobody would know that better than them.
- They think they can beat the market. Overconfident investors think they can beat the market as represented by an index stock. So they buy individual stocks betting on their perceived impeccable sense of timing. The reality is that even the very best investors do a poor job of outperforming the indexes. Heck even 90% of professional brokers, advisors and fund managers fail to beat an S&P index fund.
IS OVERCONFIDENCE HURTING YOUR INVESTMENT RETURNS?
The problem with those suffering from the Dunning-Kruger effect is that many will never admit they don’t know what they don’t know. The overconfident will never admit their deficiencies.
Some of the greatest athletes in the world spend hours upon hours addressing their deficiencies.
In the same vein, the most competent investors out there understand their deficiencies – especially in the public markets. They’re not so arrogant as to think they can beat the market. They know how nearly impossible it is to time investments to beat others playing the same game.
How can an investor avoid the Dunning-Kruger effect?
Here are some tips and reminders for avoiding the mistakes in investing that result from overconfidence.
- Wisdom comes from acknowledging our limitations. Step back and take a closer look at our actual abilities.
- Removing yourself from your comfort zone to distance yourself from your own biases.
- Consider other investment ideas and strategies.
- Don’t feel ashamed in admitting defeat and redeploying funds to a potentially better place.
We all invest because we’re all hoping to better our financial futures. The most successful investors all come to a realization at one point that changed their investing fortunes forever.
Like most investors, most ultra-wealthy inventors started out investing in the stock market. However, the day they stepped back and recognized their deficiencies AND the deficiencies of the stock market was the day they changed their investment course.
These are probably some of the revelations they discovered in their journey of discovery:
- They were likely not beating the market consistently.
- If they couldn’t beat the market, they had little hope of building and sustaining wealth.
- They needed cash flow to compound wealth and they were never going to achieve that through public equities.
- The public markets offered little opportunity to generate wealth.
- The private markets offered opportunities for cash flow and growth.
- What did they know about private market opportunities in income-producing assets like productive businesses, commercial real estate, agriculture, energy, etc.?
- Some individuals were more knowledgeable than they were.
Gravitating towards assets that truly built wealth required successful investors to adopt an opposite approach to the Dunning Kruger effect. It required acknowledging the superiority in certain fields and competencies of others.
Maybe the savvy investor knew very little about commercial real estate, but maybe a particular sponsor did and if the investor humbled themselves enough to leverage the expertise of others, this would help the investor achieve their goal of financial independence.
If your ultimate goal is to build wealth, why be your own roadblock?
Don’t be afraid to admit your deficiencies and leverage the expertise of others if doing so will help you achieve your goals. The ultra-wealthy got out of their way long ago and learned to leverage the expertise of others to achieve financial freedom.
Is overconfidence wrecking your portfolio? If so, then maybe it’s time to reassess and redeploy.
Assess where you are now and where you want to be. Take action and redeploy your investment capital without shame or fear and reap the rewards.
