The Dunning-Kruger Effect
Yesterday, Emmet and I were invited to participate in a podcast aimed at teaching people how to invest successfully. I was all geared up to talk about the basic mechanics, but, the conversation drifted towards the psychology of investing. This, I think, is a far more interesting topic, and one I don’t get to write about as much as I’d like to.
I’m going to try and rectify that and dedicate a few Insights a month to the topic. If you don’t like it, you can let me know on Twitter (@rorycarron) or, better yet, direct complaints to firstname.lastname@example.org.
Something that has always fascinated me about investing is the power of what’s called ‘The Dunning-Kruger Effect’. I experienced this myself when I was first starting out and I see it repeatedly with new investors.
The Dunning-Kruger Effect states that as you go from knowing nothing about a subject to knowing a small amount about a subject, your confidence level shoots up dramatically. However, as you continue to learn, you realize how little you know and your confidence level plummets. It then takes quite a while and a lot of learning to regain that previous confidence.
You’ll all have witnessed this if you’ve ever watched the early auditions for American Idol or X-Factor. Have you ever noticed how the really terrible singers seem to have such incredible confidence in their own abilities? They strut out in front of the judges before absolutely murdering some Celine Dion classic and then are shocked that they don’t progress. What’s happened is that they’ve sung for their relatives a few times or even had a couple of singing lessons, and have taken minor improvements to mean they are actually great singers. They are operating at the peak of The Dunning-Kruger Effect and that’s what makes the early stages of the show entertaining — the rise of hubris and the fall from grace. Pure Greek tragedy.
Meanwhile, the seriously talented singers who audition are typically very shy. What’s happened there is that they’ve been practicing for many years and understand how much work and dedication it takes to be a truly amazing performer. Therefore, their confidence is much lower — they are acutely aware of how much they don’t know.
Nassim Taleb explores a similar idea in his book ‘The Black Swan’, discussing the Italian writer Umberto Eco. Eco had a huge personal library, containing over thirty thousand books. Most visitors stared in awe at the collection, amazed that the writer could be so widely read. However, a small minority understood that the books weren’t there to boost his ego, but as a reminder of how much the writer did not know. Taleb called this collection of unread books an antilibrary.
The Dunning-Kruger Effect is particularly observable in new investors. If you knew absolutely nothing about investing and were, for example, to read our Learn App, you would instantly know more than 95% of people out there. (I don’t have data on this by the way but 95% of people I’ve met have never heard of a P/E ratio, and if you’ve read Learn then you have). Your confidence at this point should be pretty high. I’ve had users who didn’t know what a stock was a month ago pitch stocks to me.
However, there’s still so much more to learn — far more than could be summarised in an app — and when you realize that, you start losing faith in yourself. Sadly, there are no shortcuts. You have to experience investing first hand, over the course of years (decades, even) before you become fully confident in your abilities. The truth is you’ll never know everything, and just acknowledging that is a huge first step on a constant journey.