By: Flabia Maharjan
An Overview of the Dunning-Kruger Effect
Researchers David Dunning and Justin Kruger explained the phenomenon of people with limited knowledge and expertise in a field overestimating their knowledge in that domain, known as the Dunning-Kruger Effect. Simply put, a person with average skills thinks highly of their abilities. While you may think your performance is exceptional, someone with expertise would identify you as average, leaving plenty of room for improvement.
This cognitive bias closes people’s minds toward the idea of learning and hence, the need to be self-evaluated. Inability to assess yourself due to a lack of knowledge on a specific subject can lead you to believe you are making the correct decision when you are not.
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Consequences of the Dunning-Kruger Effect
People who exhibit the Dunning-Kruger Effect are ignorant of other’s progress and performance in comparison to their own. This prevents them from knowing if they are falling behind because they’ll feel like they are excelling when they’re indeed performing below average most of the time.
2. Overestimating one’s abilities
The ability to recognize one’s deficiencies in one’s knowledge stems from a basic level of knowledge on the subject matter, which is lacking in people who suffer from the Dunning-Kruger Effect. This lack of knowledge will prevent them from understanding their own mistakes, which results from decisions taken through overconfidence in their abilities.
3. Irrational decision-making
As discussed previously, people overestimate their abilities and make decisions based on the limited amount of knowledge they possess. Moreover, they will not seek advice from their peers or someone who would view them more objectively than themselves. Although they might think they are being reasonable with their choices, decisions based on limited knowledge and no constructive feedback are generally wrong.
Do Investors Exhibit the Dunning-Kruger Effect?
Dunning-Kruger Effect is common amongst investors. It translates to investors overestimating themselves and making the wrong investment decisions, eventually leading them to a loss. For instance, when people invest during the bear-bull transition period as beginners in the stock market, they may see success quickly as the value of their investment rises. It will motivate them to invest even in mediocre companies with high returns at present. Although they may just be starting their journey as investors, early success blinds them, and the desire to become full-time traders sets. As a result, they are encouraged to take loans for investment purposes and are influenced by stock market news on social media. However, they end up losing their money when the market crashes.
When investors enter the stock market for the first time, they try to be careful with their choices since they are well aware that they lack sufficient knowledge on investing. However, the initial return they enjoy (that we talked about in the previous paragraph) makes them fall prey to the “beginners bubble,” hence, leading them to take more risks. Success based on little learning can be harmful as investors feel they’ve mastered the skill of investing when it’s only a short-term success. It is for them to analyze whether they succeeded through skill or luck. The ability to do so will allow them to seek more knowledge, advice and develop essential skills.
How to Overcome the Dunning-Kruger Effect?
1. Practice Humility
The journey of becoming a successful investor is a life-long learning process. One can excel only with knowledge, experience, and patience. This is why humility is considered a crucial trait of an investor. It does not only hold for beginners but experts as well. When people pursue knowledge on a topic with utmost sincerity and humility, they only realize how much they don’t know or how much they’re yet to learn.
The best way to limit overestimating your abilities would be to assess your strengths and weaknesses. Knowing your blind spots can help you recognize what part of the market you should focus . In other words, you should put your competence to use by choosing stocks and sectors you know most about. This idea has been derived from the “Circle of Competence” theory and has been used over the years by Warren Buffett.
3. Be Open to Feedback
An incompetent investor does not know his incompetency until he evaluates himself or seeks external advice. It is because the skills required to make the right decision are indeed the skills he lacks. Therefore, as an investor, you must be able to keep your ego aside and seek advice to prevent making the wrong investment decision.
A little knowledge can be a dangerous thing. Not only does it prevent people from looking at a situation from all the possible angles, but it also misleads people into thinking they are experts in a particular domain when they are not. This sums up the Dunning Kruger Effect. It highlights concepts of incompetency and overestimation, thereby bringing our attention to humility, self-assessment, and feedback.
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