Everyone is a genius in a bull market
The Dunning-Kruger Effect
The Dunning-Kruger Effect is a cognitive bias in which people with a low ability of a given task are prone to overestimate their ability at that task. We are incapable of objective evaluation of our own competency levels. I'm writing about it as I've come to realise I suffer from it.
Dunning and Kruger's main finding from their 1999 study “Unskilled and Unaware of it” was that the worst performers consistently overestimate their ability relative to others.
I've outlined two examples of this bias in action and how you can avoid some of these pitfalls:
As the age old saying goes, "Everyone is a genius in a bull market."
When your portfolio is growing and the markets are ripping as they have in 2020, many fall victim to the Dunning-Kruger Effect. We tend to wrongly attribute this performance to our ability as talented investors.
An obvious example people have been using recently is Donald Trump, whose confidence never wavers, despite his weak interest and understanding of policy matters.
The first rule of the Dunning-Kruger club is you don't know you're a member of the Dunning-Kruger club. But we're all human, and it's important to recognise that we are all prone to this cognitive bias.
Here are a few strategies to avoid it:
Identify your circle of competence
The circle of competence is a sacred place. It's a set of topics or areas that align with a person's expertise. Be ruthless in identifying and protecting the boundaries, and it's usually smaller than you think.
As Charlie Munger said, "It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of being very intelligent."
Know your competencies, focus on them. Know your incompetencies, avoid or outsource them.
Be a first principles thinker
A first principle is a foundational assumption or proposition - it is foundational in that it cannot be deduced from other assumptions. In chemistry, it's like an element. It cannot be broken down further.
Ground yourself in foundational truths and build up from there. Challenge your reasoning, and most importantly, always ask why.
"It isn't what you don't know that gets you in trouble. It's what you know for sure that just isn't so."