Which personality trait best describes you?
When faced with a situation where people depend on you to solve a problem because they have complete trust and confidence that you’ll solve it, you doubt you’ll be able to come through.
In the opposite scenario, imagine the same group of people seeking solutions to their problems. Still, they never asked for your help because they didn’t believe you had the skills or experience to solve it. However, you feel like you can easily solve the problem even though the odds say you’re likely not to help the situation.
Most of the population relates to the person in the first scenario, who feels self-doubt in situations even when they are capable enough to deal with them. This phenomenon is known as imposter syndrome.
The person in the second scenario, however, suffers from overconfidence. This person suffers from the Dunning-Kruger effect.
Named after psychologists David Dunning and Justin Kruger, who studied and termed the effect, the Dunning-Kruger effect is a distorted reality in which people with low ability overestimate their ability and underestimate those with higher abilities, wherein the people believe that they are more capable than they are. These people tend to overestimate their real competence.
The ultimate problem with the Dunning-Kruger effect is people fail to recognize their competence levels and strengths. Hence they believe they have more knowledge and are more capable than they are. Moreover, the least skilled people overestimate their abilities, while the most skilled people underestimate their abilities.
In their research, Dunning and Kruger found, for example, that college students who hand in exams that will earn them Ds and Fs tend to think their efforts will be worthy of far higher grades; low-performing chess players, bridges players, and medical students, and medical students, and elderly people applying for a renewed driver’s license, similarly overestimate their competence by a long shot.
According to Dunning, lacking skills and knowledge leads to two problems. First, the person won’t be able to perform well in the tasks, and the second is they will not be able to realize their mistakes and lack of skills, which Dunning proposed as a double burden. 9 Dunning-Kruger Effect Examples in Real Life, studiousguy.com.
It’s in the world of investing where the Dunning-Kruger effect can get people into the most trouble – especially in the stock market.
Everybody thinks they can outsmart the market, whereas the data clearly shows that the vast majority fail to do so. Everybody thinks they can do better than the average. This overconfidence makes people fail to see their deficiencies and often results in bad decisions. This overconfidence results in investors suffering significant losses because they’re usually out of their depth and don’t learn from their mistakes. They double down on their ability to dig themselves out of a hole when, in fact, they only dig a deeper and deeper one.
Here are typical mistakes of overconfident investors:
1. They think that the stock market is the only way to make money and are confident they can beat it. Investing for most folks is about timing – buying low and selling high or selling before the downturn. Investing is about speculating for most investors, and many are unwilling to consider any other form of investing – like in alternatives or private markets where it’s not merely about timing or speculating.
The typical investor has a short investment window. They buy individual stocks betting on their impeccable sense of timing. In reality, even the very best investors do a poor job of outperforming indexes. They may get lucky once in a while, but few investors can sustain success. Even 90% of professional brokers, advisors, and fund managers fail to beat an S&P index fund. What chance do average investors have?
2. They Speculate and Lose. The vast majority of investors fail at the timing game and fail to beat the market. Either they hold losing investments for too long or sell winners too soon. And because it’s difficult for overconfident investors to admit a mistake, they will continue their bad habits.
In investing, it’s better to have impostor’s syndrome instead of suffering from the Dunning-Kruger effect. With impostor’s syndrome, investors admit that they don’t know what they don’t know. By admitting this, they’re more willing to rely on experts or to seek out knowledge on their own to learn about the true nature of speculative stock investing and to seek out alternative investments that offer a different path. It’s how most smart, ultra-wealthy investors started – by gaining knowledge and leaning on mentors. Even Warren Buffett had a mentor in Benjamin Graham.
On the road to financial independence, it will serve investors to acknowledge their limitations and learn from others. Overconfident investors tend to bite off more than they can chew. Invest in sectors like FinTech, pharma, and crypto because they overestimate their abilities because of the Dunning-Kruger effect. The effect is investing failure and the failure to recognize incompetence. The ultimate result is losing money.
Do not let your confidence lose you money and keep you from seeking investments that will give you the best chance at financial freedom.
Make investments that you can understand or that you can learn from others. There’s nothing wrong with admitting your deficiencies and leveraging the expertise of others if doing so will help you achieve the financial freedom you covet.
