Why it’s OK not to know everything about investing

Overestimating our capabilities can lead to an inflated sense of confidence - and costly mistakes

It is important to continuously educate ourselves and acknowledge that it is impossible to know everything. Getty

In 1995, a man committed a brazen daylight robbery of two American banks without wearing any disguise. He even smiled at the surveillance cameras before leaving.

The police apprehended him that same evening. Strangely, upon being handcuffed, the robber appeared perplexed and muttered the words: “But I wore the juice.”

It turned out he believed that rubbing lemon juice on his face would render him invisible to the security cameras.

He was quite confident in his belief, as the chemical properties of lemon juice are used in invisible ink (so he expected that they should render him invisible, too). This thinking was clearly abnormal.

However, what is particularly intriguing is that even after being presented with footage of his own robbery, the man was genuinely taken aback his trick did not work. He believed the footage was fake.

The police concluded the man was not mentally unstable or under the influence of drugs, but simply misinformed and mistaken.

This comical incident caught the attention of two social psychologists, David Dunning and Justin Kruger, who conducted further research into the incident. They were particularly interested in the man’s unwavering confidence.

Mr Dunning and Mr Kruger first conducted a study involving a group of undergraduate students, who were evaluated based on their grammatical writing, logical reasoning and sense of humour.

They were then asked to estimate both their overall score and relative rank compared with their peers.

After the actual scores were revealed, Mr Dunning and Mr Kruger made a fascinating discovery.

Students who performed the poorest on the cognitive tasks consistently overestimated their own performance by a significant margin, believing that they had scored well above average when their scores were actually the lowest.

These students not only demonstrated incompetence or lack of skill in these areas, but also a lack of awareness regarding how poorly they had performed.

Mr Dunning and Mr Kruger also found that students who scored the highest on the tests had more accurate perceptions of their abilities. However, they made a different type of mistake.

Paradoxically, the highest-scoring students tended to underestimate their performance.

While they were aware that they were above average, they assumed the tests were easy for everyone. Thus, they were not aware that their ability was in fact in the top percentile.

The Dunning-Kruger effect is a phenomenon that describes how low-ability individuals lack the skills necessary to recognise their own incompetence or lack of knowledge.

Due to poor self-awareness, they tend to overestimate their own capabilities, leading to an inflated sense of confidence.

As they become more knowledgeable in a specific area, their confidence often decreases.

However, when they become above average in a skill, their confidence in that area can start to increase again.

Interestingly, this effect is not limited to cognitive tasks, but can also apply to any skill or activity.

Essentially, the less someone knows about a particular subject or skill, the more likely they are to overestimate their own proficiency in it.

The Dunning-Kruger effect can be seen all around us, including talent shows such as American Idol.

During auditions, there is typically a mix of good and bad singers.

Those who are not skilled in singing tend to lack the ability to recognise this, which can result in them being genuinely disappointed when they are rejected, as they were not aware of their lack of skill (humans are often not very good at accurately evaluating themselves, due to cognitive biases.)

It is a common tendency for people to believe they are better than average, even when evidence may suggest otherwise.

For instance, studies show that 95 per cent of people consider themselves better drivers than the majority, and even elderly people often rank themselves among the best drivers.

Additionally, 88 per cent of investors assume they are better than their peers.

This is a curious phenomenon as it goes against basic mathematical principles.

The question remains: Why do people with lower skill levels tend to be more confident in their abilities? Here is an analogy to help.

Imagine Alex, a self-taught investor who has read a few books and subscribed to a few blogs. With this newfound knowledge, he feels confident in his abilities and believes he knows a lot about investing.

He even has a basket full of index funds. With this reasoning, he is easily at the top percentile of all investors.

But let us say he meets a financial planner, someone who has been doing it all day, every day, for 10 years, and still has a lot to learn.

The financial planner knows the field of investing is much larger than what Alex has learnt, and there is much more to know.

Alex is overconfident, with only a little knowledge of the field and doesn't realise how much he does not know.

As a result, he incorrectly thinks he knows about 90 per cent of what there is to know about investing.

Conversely, experts tend to have a more accurate perception of their knowledge and abilities.

However, they may make a different mistake by assuming that everyone else is as knowledgeable as they are, often due to others projecting confidence.

The financial planner is aware he knows only about 70 per cent of what there is to know about investing. However, if he were to meet someone such as Alex, he may perceive himself as less knowledgeable (after all, 90 per cent is a higher percentage than 70 per cent).

The Dunning-Kruger effect can affect all of us, but there are ways to avoid it.

The key is to continuously educate ourselves and acknowledge that it is impossible to know everything. You are not expected to know everything. But thinking you are always right is foolish.

It is a paradox: The more knowledge people acquire, the more they become aware of their ignorance.

As people gain an understanding of a particular topic, they begin to grasp how intricate, uncharted and vast it is, leading them to recognise the extent of what they do not comprehend or have yet to learn.

Conversely, people who merely scratch the surface of their pursuits will remain oblivious to how much they truly have left to learn.

According to the Dunning-Kruger experiment, unskilled students improved their capacity to accurately estimate test results after receiving rudimentary coaching on the abilities they were deficient in.

Thus, having a mentor or teacher guide you towards areas that require improvement can be beneficial.

If you ever feel overly confident in your knowledge of a particular subject, take a step back. It may be a manifestation of the Dunning-Kruger effect.

Sam Instone is co-chief executive of wealth management company AES