The Dunning-Kruger Effect

Chas Craig, BridgeTower Media Newswires

“That recherché minority which at other times has acknowledged its interest in Saint Thomas Aquinas, Proust, psychoanalysis, and psychosomatic medicine then spoke of United Corporation, United Founders, and Steel. Only the most aggressive of the eccentrics maintained their detachment from the market and their interest in autosuggestion or communism.”
– John Kenneth Galbraith, The Great Crash 1929

In a late December 2020 column in which I drew parallels between poker and investing, the Dunning-Kruger Effect was introduced. The Dunning-Kruger Effect is a cognitive bias that predicts that the most ignorant people on a subject will be the least aware of their own ignorance and, therefore, will overestimate their ability in a given field.

A January 16, 2021, article by ZeroTwoOne entitled “Everyone is a genius in a bull market: The Dunning-Kruger Effect” illustrated the concept brilliantly via the use of a simple graph, which I will describe. The vertical axis plots confidence, ranging from low to high. The horizontal axis plots wisdom, ranging from know nothing to expert. The graph illustrates that humans’ confidence tends to spike significantly higher after acquiring a small amount of knowledge on a subject; the author calls this the “Peak of Mt. Stupid.” However, as we acquire more wisdom, we start to realize that we have a lot more to learn. As a result, our confidence collapses, the author describes this as the “Valley of Despair.” From there, as we gain more knowledge and experience our confidence is slowly restored, a period dubbed the “Slope of Enlightenment” eventually reaches the “Plateau of Sustainability” where we continue to add to our wisdom bank and our confidence level is sustainably on par with that when we were at the “Peak of Mt. Stupid.”

The essence of the “Peak of Mt. Stupid” was captured well by Mr. Galbraith in The Great Crash 1929. He said, “That much of what was repeated about the market – then as now – bore no relation to reality is important, but not remarkable. Between human beings there is a type of intercourse which proceeds not from knowledge, or even from lack of knowledge, but from failure to know what isn’t known.“ The whole conversation on the Dunning-Kruger Effect also calls to mind then-Defense Secretary Donald Rumsfeld’s famous observation regarding terrorism and Iraq. He said we have things we (1) Know that we know (2) Know are unknown and (3) Don’t know that we don’t know.

So, how do we counter this cognitive bias that could cause us to make irrational investment decision, or irrational decisions generally? The ZeroTwoOne article provided two helpful pieces of advice. The first is to identify your circle of competence and stay there. To make the point the article quoted Warren Buffett’s longtime business partner, Charlie Munger, who once said “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of being very intelligent.” The second piece of advice offered was to be a first principles thinker. To quote the article, “Ground yourself in foundational truths and build up from there.”

Personally, it is a humbling experience to recount my journey on the confidence/wisdom curve and to consider where on the curve I might be now. Additionally, to tie back to the prior column on bubble prerequisites, the confidence level of many new entrants to the market, particularly those participating in popular online chat rooms, seems quite high. Whether this confidence level is associated with the “Peak of Mt. Stupid” or the “Plateau of Sustainability” remains to be seen. I have my suspicions.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).