In continuing our discussion of the psychology of investing and cognitive bias, there can be no better place to start than with the following. In domains in which we possess some competence, we tend to estimate our competence to be greater than it is. The reason for this is because we don’t know what it is that we don’t know.
The more competent we are/become, the we more we realise/understand what we don’t know. This is where we want to be, a place where we know our limitations. This cognitive bias, whereby those with a lesser level of knowledge in a particular domain mistakenly assess their knowledge and ability as more remarkable than it is, has a name. It’s called the Dunning-Kruger effect, named after the two Nobel-prize winning scientists who identified the phenomenon.
Now, you might be thinking that the Dunning-Kruger effect sounds a lot like the cognitive bias known as overconfidence, and you’d be right. Overconfidence refers to the tendency humans have to overestimate their abilities. This tendency occurs in many facets of human life but, to give an example, it has been demonstrated that more than 90 percent of people think that they are better than average drivers. Logic dictates that this is an impossibility, but the belief occurs because driving is a domain in which nearly all of us possess at least some competence. And as such, we tend to estimate our competence as greater than it is. Another psychological study demonstrated that when people say that they are 100 percent certain that they are right about something, they tend to be right about 75 percent to 80 percent of the time.
So how are the Dunning-Kruger effect and overconfidence problems in the world of stock market investing? Well, overestimating one’s knowledge and ability is a dangerous thing when it comes to investing, and it can lead to some very poor investment decisions. Also, it doesn’t just happen to novice investors… one study found that when analysts are 80 percent certain that a stock will go up, they are correct about 40 percent of the time.
How to address these cognitive biases is a tricky question. Firstly, it’s essential to maintain an awareness that we tend towards overconfidence and attempt to neutralise this by reminding ourselves of this fact whenever we make an investment decision. A little knowledge can evidently be a dangerous thing and, as such, it is important to avail yourself of advice and guidance from those who do realise the limitations of their knowledge. It’s very easy to think you know more than you do, only to be humbled by a trade that goes horribly wrong. And while those who recognise the limitations of their own knowledge won’t always get it right, they will hone their craft, remain disciplined, stick to what they know, and become great at it, all the while acknowledging there’s much they still don’t know.
So let’s embark on a journey into the psychology of investing, armed with Dunning and Kruger to help us sidestep this cognitive landmine. After all, this phenomenon shapes the very basis of all we do in the stock market and determines how we approach the myriad other cognitive biases that await us.
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