Confidently Wrong: How the Dunning-Kruger Effect Impacts Your Money
"The first rule of the Dunning-Kruger club is you don’t know you’re a member of the Dunning-Kruger club"
“We Are All Confident Idiots”
-David Dunning
We all have that friend who acts like an expert on every topic that comes up in conversation. At the beginning of the night, they are giving you stock tips, and by the end of the night, they are explaining to you how the science of vaccines works—neither of which are topics they know anything about.
That friend has fallen victim to the Dunning-Kruger effect.
The inverse correlation between skill and ability
The Dunning-Kruger effect was first discussed in a paper written by Justin Kruger and David Dunning titled “Unskilled and Unaware of It: How Difficulties in Recognizing One's Own Incompetence Lead to Inflated Self-Assessments.”1 The title of the paper perfectly describes what the Dunning-Kruger effect is; people with little knowledge of a particular subject wildly overestimate their abilities.
Think of the finfluncer who started investing 16 months ago and has the delusional confidence to sell online courses on trading stocks. Experienced investors with deep knowledge of financial markets have educated themselves to the point that they would never dream of selling a stock picking course for two reasons.
Markets are fairly efficient, and beating the market consistently is exceedingly rare.
Even if someone is so good that they can consistently beat the market, It’s laughable to believe they could teach someone else how to do it.
But, the 20-something finfluncer does not know enough about financial markets or their abilities to recognize either of these points.
That’s the Dunning-Kruger effect.
Dunning-Kruger comes for us all
It’s difficult to write about the Dunning-Kruger effect without sounding pretty harsh. How do you say, “you’re an overconfident idiot” in a nice way? It reminds me of Cousin Greg from Succession, who once asked, “do you think it’s possible to sue a person in an affectionate way?”
But the truth is, falling victim to the Dunning-Kruger effect does not make you an idiot because the Dunning-Kruger effect comes for us all eventually.
If you doubt that, David Dunning has a message for you.
“The first rule of the Dunning-Kruger club is you don’t know you’re a member of the Dunning-Kruger club.”
— David Dunning
You can be a brilliant, successful person, but there are likely many different subjects that you know next to nothing about—which is harmless as long as you understand and accept you are not an expert in that particular field.
To be a successful investor, you don’t need to know as much about the stock market as Warren Buffett. People get into trouble when they believe they are an expert or can easily become one and start engaging in wildly risky strategies like options trading—where you can wipe out your net worth with a few mouse clicks.
You can have novice-level investing knowledge and still be a great investor if you know the basics of diversification and hold for the long run.
While investing is an obvious arena where the Dunning-Kruger effect comes into play, it’s certainly not the only one. Anyone can be confident and wrong about any money-related decision.
Buying a new or used car
Buying or leasing a car
Whether to get the extended warranty
Buying or buying a home
Paying a premium for “organic” food
Negotiating salaries
How much to save for retirement
For every important financial decision, there is the possibility that you have no idea about the subject at hand-but you think you do. This causes a double dose of financial pain:
You make a terrible financial decision
The lousy decision goes uncorrected because you are unaware of your error
I know people who make a lot of money, and they can deduct the cost of a car lease against their income for tax purposes. They (wrongly) believe that this means the best financial decision is to get the most expensive car lease possible so that they can deduct more from their taxes.
They fail to realize that just because you can deduct a cost from your taxes does not make it “free.” But they confidently believe that an $800 car lease is better than a $500 lease. Since they are unaware of their error, they continue making the same mistake (with confidence) every time they buy a car.
The most damaging aspect of the Dunning-Kruger effect is not that you will make a mistake; it’s that the mistake will go unaddressed.
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Can overconfident ignorance ever be a good thing?
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