Sometimes not knowing what you don’t know, is even more dangerous than not knowing in the first place. That’s especially true in investing.
In the aftermath of the 2008-2009 global economic crisis, the Financial Industry Regulatory Authority (a stock market regulator in the U.S.) and the U.S. Treasury conducted a study to find out how much people thought they knew about finance and investing. Respondents were asked to rate their own financial knowledge, and they were then tested to see how much they actually knew.
About 800 of the 25,000 participants in the study had previously filed for bankruptcy. This group performed poorly on the test, finishing in the bottom half. But even though members of this group had concrete evidence of their poor financial skills, they still rated their financial knowledge, on average, as superior to that of the other study participants.
The tendency of people to think they’re smarter than they really are is called the Dunning-Kruger effect, named after the Cornell University psychologists who first experimentally observed it.
One of these psychologists, David Dunning, found that ignorance, not arrogance, is the main reason for this bias. Because we have strong preconceived notions about ourselves, we sometimes have trouble accurately assessing our own abilities. Dunning also found that it is the least skilled or talented who tend to overestimate their abilities the most.
Investors sometimes exhibit this tendency — they think they know more than they actually do know — in part because they have access to so much information, data and figures. It’s easy to mistake information for real insight. And the financial media can promote this attitude by simplifying complex research and analytical processes into a single, easy and definitive conclusion: Buy (or, occasionally, sell). This simplification can lead to an overestimation of our own knowledge.
Addressing the Dunning-Kruger effect requires an honest assessment of your abilities. It also means that you always need to be learning, gathering new insight – and understanding the depths of your own ignorance. Exchanging ideas to get feedback on your thoughts and ideas will also help keep you grounded.
Donald Rumsfeld, a former Secretary of Defense of the U.S., famously said, “… as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.” When Rumsfeld said this (in 2002) he was referring to whether Iraq had weapons of mass destruction. Understanding your own unknown unknowns is a critical element of self-awareness for investors.