Everybody wants to be a great investor. We love the idea of outperforming the markets, or at the very least, beating our peers. The problem with all this foolishness is that nearly all of us lack the skill set and discipline required to create those better than average returns. Worse yet, we often fool ourselves into believing we are much more skilled than we actually are.
We don't get a game.
I'm Barry Ridhelts, and on today's edition of At the Money, we're going to discuss metacognition, our ability to self evaluate our own skills. To help us unpack all of this and what it means for your portfolio, let's bring in Professor David Dunning of the University of Michigan. He is the author of several books on the psychology of self and best known for his research known as the Dunning Kruger Effect. So welcome, Professor Dunning. Let's start with the basics.
What is the Dunning Kruger effect.
The Dunning Kruger effect is the basic idea that people who lack expertise lack the very expertise they need. To recognize the fact that they lack expertise, that is, if you don't know, you don't know what you don't know. And so the basic problem people have is they fail to recognize their own ignorance when it comes to their skill or if it comes to any particular decision that they may have in front of them that day.
So it sounds like metacognition is a separate skill from whatever fields we may be working in it. It could be business, it could be financed, it could be sports. The ability to self evaluate is its own ability.
Well, it certainly is its own task that we have to come to a decision or at least some sort of judgment, and then there's a second task of should we be confident in that decision or should we have doubt? And that's that second task, and often that's the important one that determines whether or not we're going to act, or whether we're going to seek advice or hedge or seek insurance. And it does have some skills associated with it, but often doing the second task well requires the same knowledge,
the same expertise as doing the first task well. And that's where the dudding Kruger effect comes in. That's the paradox, the conundrum, the issue, But it is a second task that is very very important.
So if we are not expert in a given space, it sounds like that implies we also lack the ability to judge our own lack of expertise.
That's right. We have a as we call it, a double burden. We lack the skills to make the correct decision in the first place. That also means we don't necessarily have the skills to be able to evaluate the decisions that we've made.
So this seems to be a very common problem in the field of investing. With newbies or people who are early in their investment career, they have a little bit of success, sometimes it's luck, maybe there's some skill involved or some combination of both, but they develop a bit of overconfidence and that allows them to forget about, Hey, maybe I'm not an expert. How dangerous is this out there in the world.
Well, it can be dangerous. One thing to point out is that it's a danger for everybody, no matter what your level of expertise is. As soon as you step into your own pocket of incompetence, well you're vulnerable to this effect. But if you're new to something, and you're very vulnerable to this effect. If you're learning something if you have a little experience. While your experience is valuable,
but you may overplay its value. You may overlearn what you've learned from just a little bit of experience with something. And I think you know things that actually turned out to be luck or misteries the situation, and that could leads you to fall prey to the Dunning Kruger effect.
So this sounds a little bit like overconfidence. How does Dunning Kruger effect differ from just straight up having too much belief in your own abilities?
Well, overconfidence is a general phenomenon and you can find it everywhere. I would actually argue that overconfidence is inevitable. In some sense, it's something that we're all going to experience, and in a sense it's something that we all have to manage. It's just an inevitable fact of life. What the Dunn Kruger effect is is just one particular ingredient, one spice that can lead people into overconfidence. That is, when you are not an expert, when you're in a
situation that's new to you. This is exactly when you're in a situation where you may become quite overconfident. You may think that you've got this, when in fact you're nowhere near having this if you will. It's one of the situations where overconfidence maybe it's most pointed or it's most severe.
So how should we think about our own blind spots? What can we do to make ourselves more self aware of the areas that we need some improvement in.
One of the things I keep thinking about is to resurrect that old Apple slogan, Apple computer slogan of thing different, to ask other people what they think and see if they think something different, or do what the professions, being a lawyer or being a doctor do. If you look at the professions, they actually institutionalize thinking different. In the American legal system, if you're a lawyer, you present your case and there will be another law who is going
to think different from you. In fact, that lawyer is going to think the opposite of you, and it's going to poke holes in every single argument you make. They will be thinking different. The idea in the legal systems, the truth will come out of that competition between your side and the other side. Doctors don't make diagnoses. They do differential diagnoses. They don't consider what your problem medical
problem might be. They consider multiple medical problems and trying to figure out what rules in this medical problem, what rules out these other medical problems.
So poor performers generally overestimate their skill at performance because their incompetence deprives them of the skills they need to recognize that deficit. What else should we be doing to avoiding those sort of problems you talked about speaking to other people, we talk about thinking differently. What other options do we have in our toolkit to avoid these mistakes?
Always be learning? That is the easiest way to avoid the problems of incompetence is to become competent. Although that's very easy conceptually. I know it's hard to do in reality, but you can always become more competent if you will.
It can always be learning. One of the things I tell my graduate students the way you want to feel is if you take a look at something you've done in the past, like some sort of research study you've created or something you've written, is that you should always feel vaguely embarrassed by it, that there are things you wish you'd done differently. And if you feel that way, that that's a very good feeling because that means you've grown. If you're perfectly satisfied with it. I would be scared.
That means you haven't grown. And I myself am delighted to say I continue to embarrass myself constantly all the time. When I read myself, even in the recent past, I'm delighted that I'm still an embarrassment. I wish it would end, But then again, I wish it wouldn't end.
Huh. Quite fascinating. So to wrap up our inability to evaluate our own skill sets, especially when we're first starting out as investors, is a very troubling and potentially expensive human trait. However, if we find ourselves mentors, if we're always learning, if we look back at what we used to do and recognize, hey, that's a little embarrassing, it
means that we've come a long way. As long as we can objectively measure our performance, take steps to get better, and try and stay within our own abilities, we can have much better outcomes. I'm Barry Rudults. This is Bloomberg's at the Money.
We don't get proved again. A