Head In The Cloud and Dunning-Kruger

I recently read Head In The Cloud by William Poundstone. The book’s thesis is that it’s still important to know things even in the age of Google where facts can be pulled in seconds. The entire first part of the book is dedicated to the Dunning-Kruger Effect: “Those most lacking in knowledge and skills are least able to appreciate that lack. (p. 10)”

dunning-kruger effect definition

In the book, Poundstone references a Pittsburgh bank robber who would commit heists in broad daylight without wearing a mask. When caught by police soon after, the bank robber said, “but I wore the juice.” This idiot thought that squeezing lemon juice on his face would make him invisible to the security cameras. Apparently, the connection was made after he realized that they use lemon juice in invisible ink. So, of course it would also make people invisible.

You get the idea. People who don’t know things also are the first who overestimate their abilities. And this is where we get into my beat, investing. Reading Poundstone’s book made me realize that the Dunning-Kruger Effect applies to investors. How many people think they can beat the market? Also, I wonder how many people with little market knowledge think they can easily get rich in the stock market.

I’m Genius But Incompetent

I know a guy who used make swing trades in the market. We’ll call this guy Bull. Bull and I used to work together years ago. I had a couple years life experience on him and a ton of market experience from trading in my own account. Bull thought this investing in the stock market stuff was EASY. His method was to take his entire life savings and buy one stock that he thought would do well.

Now before you go laughing out loud or crying depending on your personality, realize this: Bull wasn’t putting more than $15K in his swing trades. If he lost it, it would have hurt him but he was young. He could recover in time.

Bull’s stock was Ford (F). His first couple of trades actually worked out well. He made a thousand or two within a matter of weeks. This added to Bull’s confidence level. He would walk around the office telling everyone he could about his investing success, his intellect, his ability to know what other people didn’t. (I imagine this is how a lot of chartists act. Reading the Bollinger Bands like tea leaves and “knowing” more than the non-chartist.)

Then Mr. Market came in with the Great Recession while Bull was in full-swing mode. The lesson came quickly and painfully for Bull. He stopped talking about trading or investing. He, at one point before the crash, was even talking about starting his own trading LLC with some goofy name. I didn’t get a business card.

I don’t  actually know what happened to Bull’s account. Did he lose half? Was he trading on margin? Not sure but you can substitute many other people in for Bull. Was he a dumb guy? Hell, no. Was he ignorant of investing? Sure was.

Now back to Dunning-Kruger and investing. Bull didn’t know anything about investing in the stock market but he thought he did and this is a very dangerous combination.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain

Bull was very confident in his abilities as a trader without knowing anything about investing. I mean this guy thought that an expensive stock was one that had a high per share price, not realizing that there were earnings behind each share of stock. Bull was on the far left side of the Dunning-Kruger Effect chart, with just enough knowledge to get himself into trouble.

How To Fight Dunning-Kruger

Every time I read about Dunning-Kruger or other behavioral conditions, I wonder how I’m being duped by my own human tendencies.I’m aware of cognitive biases but they’re still sometimes hard to keep front of mind. Charlie Munger spoke at Harvard about his 24-point framework of the psychology of human misjudgment.

Munger is one of the all time greats, helping Warren Buffet and Berkshire Hathaway achieve a 19% annual return for over 20 years. His 24-point framework is a must read /”hear” for everyone,  but especially investors. I think his framework can be used to fight Dunning-Kruger and overall human flaws as well.

Here are some ways to fight the Dunning-Kruger Effect in your own life:

1) Know what you know and know what you don’t know. The first step in fighting Dunning-Kruger is to actually know things. Simple enough in theory but not always that easy in practice. Obviously each of us know that lemon juice will not make us invisible. But what’s not so obvious are how to invest in the market or other complex issues.

2) Be humble when you achieve “expert” status. It’s important when you know things and even become an expert on a subject, to be humble. Humility allows us to continue to learn and be open to other ways of doing things. This is something that appears to be very difficult for experts to do. It’s easy to write other people’s opinions off because I’m the smart one. I’m the one who knows more than you. My logic is better than yours, etc. etc.

3) Encourage debate and differing opinions. Being stuck in your own head’s echo chamber will limit your ability to expand and make you susceptible mental blind spots. The best way to figure out if your idea is decent is to see if it holds up to scrutiny. For example, you should be able to put your portfolio allocation in front of other people to get feedback. You’re not in this alone.

4) Reach out to your Board of Directors for advice. When I say Board of Directors, I mean the people you trust: friends, family, bartenders. I need to do more of this instead of thinking that my way of doing things is the best way. Why not get feedback from smart people in your life?

Other Cognitive Biases To Be On The Lookout For

The Dunning-Kruger Effect is a cognitive bias but it’s not the only one. Munger counts 24 biases to be on the lookout for. Some of these biases stick out to me more than others. I’ve listed below ones that I try to take extra care not making.

#3 on the list: Incentive-caused bias – This is being biased to a certain way of doing things / thinking because you’re being incentivised to do so. I’ve been extremely careful in my life not to get caught up in this. You don’t have to look any further than an insurance salesman who gets a commission for sticking you with God-awful fee-ridden annuities. Of course this salesman thinks that you should “invest” in an annuity. He’s obviously biased: his livelihood depends on it.

#4 on the list: Bias from consistency and commitment tendency – Once you think or say something, you’re bias toward it going forward. We discount any contradictory evidence to our initial conclusion. Think about this one in your own life. I bet there is something that you think is true despite there being contradictory evidence. This isn’t easy to see either. It takes time to think about and ultimately determine if you have a commitment tendency. Take the recent IPO of Snap, Inc. for example. Someone who purchased this IPO at a sky-high valuation is more likely to think they made the right decision. “Snap is bound to go even higher,” they exclaim. All the evidence that I see points to the opposite conclusion.

#17 on the list: Bias from the non-mathematical nature of the brain and its tendency to get probability wrong – Humans are just plain bad at statistics. Now of course there are a lot of mathematicians who would argue against that. I’m not saying that we as humans can’t comprehend standard deviation or r-squared. I’m saying that as humans we’re more emotional and less statistical. We make decisions based on how we feel most of the time. It’s hard for most people to comprehend the larger statistical picture and not react on an emotional basis.

It’s fascinating to see these biases and how they distort our world view…and even our investing philosophies. The Dunning-Kruger Effect is probably one of the more interesting biases to discuss because we all know an over-confident idiot.

dunning-kruger effect

By | 2018-01-01T20:44:41+00:00 March 15th, 2017|Investing|0 Comments

Leave A Comment