Avoiding The Dunning–Kruger Effect
In 1981 a researcher named Ola Svenson asked a series of students in Sweden and the United State how they would rate their driving ability. The result — a full 93% of the U.S. students rated their driving ability as “above average”, and 69% of the Swedish students did the same.
Clearly it’s impossible for the entire 93% to be above average. A good portion of those students were simply over estimating their driving ability. By definition, half of those students should be above average and the other half should be below average.
When given the chance to evaluate our own abilities, humans overestimate our skill level. Similar experiments have been repeated around the world, and many cultures exhibit this same behavior. It is a cognitive bias is known as the “Dunning-Kruger Effect“.
In 2006 another study was conducted — this time on mutual fund managers. Of the 300 professional fund managers interviewed, a full 74% rate their ability as above average, 26% rated their ability as average, and 0% rated themselves as below average.
As we know, most actively managed mutual funds don’t outperform their indexes — Over the last 15 years, a full 82% of funds have under-performed!
This under-performance is one of the main reasons why people now invest in index funds. When professional stock pickers can’t match the performance of the S&P 500 over a 15 year period, they’re clearly not a good choice for your investing dollars.
How To Be A Bad At Financial Independence
Why am I writing a post? I worry about falling prey to the Dunning-Kruger effect. I worry It might be the cause of financial independence failure. I worry about my ability to invest, and to budget for all reasonable economic conditions. Can I see through my Financial Independence plan?
“In short, those who are incompetent, for lack of a better term, should have little insight into their incompetence”
It’s a problem of arrogance. According to Dunning and Kruger, under-skilled individuals tend to over estimate their abilities. Meanwhile highly skilled individuals tend to have lower over-estimations.
So just being highly skilled didn’t entirely solve the problem — Even skilled individuals can overestimate ability. Humans are quite the arrogant bunch!
When you read personal finance blogs, how often do you see a blogger say “I might actually suck at this.” Not often I’d bet. Blogging is a cult of personality written large all over the internet.
It raises the proverbial hair on the back of my neck.
And what about me? It’s been years since I read about the Dunning-Kruger effect, and I’m still uncertain if I over-estimate my own abilities. It’s hard to tell which side of competence you land on. As Dunning stated, “If you’re incompetent, you can’t know you’re incompetent”
Hmm…
So what should an FI seeker do? Give up entirely and head back to work under the safety-net of a regular paycheck?
This is common advice when dealing with financial uncertainty. It certainly seems like the safest option… but I’ve never been the kind of octopus that just “gives up.”
Take The Beginner Mindset
After some thought, I realized the only recourse to not deluding myself into over-estimation, is continuous education. Education is the only real cure for ignorance, and Dunning/Kruger’s research supports this idea.
Only with further education can we begin to truly identify our incompetence. Never assume you’re some kind of expert. Always maintain the mindset of a beginner, and try to keep learning.
Want an example?
After I read about Ola Svenson’s research on driving ability, I made a personal decision to believe I was a bad driver, and act accordingly.
Even though I have plenty of driving experience, I don’t assume experience makes me a better driver. I already know my reaction time has declined significantly from when I was younger (terrible performance at video games taught me that). Now, I purposely don’t drive fast and I give lots of extra room to the car in front of me. That way I don’t need to have good reflexes. I drive like a beginner, expecting to make mistakes.
I also know that in-car distractions cause a large number of car accidents. As a bad driver, it makes sense that I should remove all distractions from the car. I don’t talk on the phone when I’m driving. I don’t eat, or even talk to passengers much. I tell myself, “I’m a bad driver, and if I don’t focus completely I’ll screw-up and hit something.”
Does this counter intuitive thinking make me a better driver? It’s unlikely. It’s more likely that I’m actually a bad driver, but one who gives a little more room to correct for my mistakes.
Maintaining a beginner mindset certainly won’t feed my ego, but it might keep our car insurance bill a little lower.
Lower Your Expectations
How about investing? Should I mindlessly assume the 4% rule is going to work well into the future? Or, should I assume future market returns will match the historical 7% long-term rate of return?
It seems foolish to make such assumptions. I’m not a super investor like Warren Buffett. In fact, as I’ve written about on this blog several times, I’m almost certain I will under-perform the index to some degree. (As will most investors) My intention is to under-perform the index on purpose, but to do so in a way that means I always keep compounding.
I invest specifically to decouple my returns from the broader market. For example — right now I hold a ton of cash. I do this knowing my return will probably lag the S&P 500 to some extent. I’m not trying to be the next Peter Lynch here, but Iam trying to keep compounding if the markets hit a rough patch.
Yes, it’s true that I may have outperformed for a couple of years (in 2015 especially), but I attribute this to luck, not personal skill. I’m still learning…
I should also lower my expectation for future returns, since under-performance is almost a mathematical certainty. The 4% rule? Nah, I’m shooting for 2%-2.5%.
When do I suddenly become a competent investor? I have no idea. I need to work hard and keep studying.
Today I regularly read annual reports, quarterly filings, investment books, prospectuses, business newspapers, trade publications… really anything I can get my hands on to learn more about investing.
Blind Faith
I supposed I could just “give up” on this learner mentality put my complete faith into indexing. Interesting idea, but that could be an example of the Dunning Kruger Effect at work. Let’s say I put my blind faith into an index fund — perhaps because it’s the conventional way of investing, or a belief in my superior personal finance knowledge. At that point, I’m then either overestimating my ability to make sound personal finance decisions OR overestimating my ability to understand what indexing will return.
Either direction is folly. “Dammed if you do” and “Dammed if you don’t.”
Indeed, some of the most skilled investors on the planet agree that indexing will probably fail to work at some point. The problem is, not if, it’s when…
These kinds of issues around investing are what drives me to maintain a hybrid portfolio — A mix of many kinds of financial assets (stocks, bonds, cash, preferred shares, REITs, etc).
I try not to pick put 100% blind faith into any one investing vehicle.
The Too Hard Pile
Of course, humans are humans, and each of us has very limited time on this earth. We don’t have infinite time to become an expert at everything. We can choose to be “smart in spots” and “dumb” in others… and then try not delude ourselves into thinking we know it all.
It’s perfectly OK to say, “I don’t know enough. That’s outside my area of expertise.”
For example, the guys on CNBC predicting the stock market will crash in 2019? The’re just predicting the future, and I’ve yet to meet anyone that has mastered that trick.
This reminds me of something Charlie Munger once said, “Part of our secret is that we don’t attempt to know a lot of things. I have a pile on my desk that solves most of my problems – it’s called the ‘too-hard pile’
Yep, even one of the best investors in the world admits to “Not knowing it all”. That, right there my friends is competence. We can only hope to be as sane and competent as the great Charlie Munger.
If you haven’t read Poor Charlies Almanac, I highly recommend reading it. The book is just filled to the brim with intelligent quotes like that.
So what do you guys think? Do I have enough mental competence to succeed at this Financial Independence gig? Or, am I just deluding myself as the Dunning Kruger Effect suggests most people do?
[Image Credit: Flickr]
I’ll be at a 2% or less withdrawal rate if I stop my one day a week consulting some day. But that’s not based on statistics, I just over saved and then inherited even more. However I am not aware of any historical analysis that would result in a safe withdrawal rate any lower than 3%. Is that you just picking a number out of the air or do you have a mathematical basis for it?
It’s not random. Economic growth rates are half of what they were during the Trinity study. Thus half of 4% is going to be around 2%.
Ok. I’ve seen estimates as low as 3% backed up by models. These were forced to use assumptions that were historically unrealistic in an attempt to predict a “it’s different this time” safety margin. I don’t remember anyone predicting a max safe withdrawal rate as low as 2%.
I’ve seen those 3% projections too, but I lean to the more conservative side given some expected ‘reversion to the mean’ type declines.
Make no mistake — when the growth stops, or turns negative this nice positive market will turn very negative.
Sure, makes sense to be conservative. I’m right where you are feeling 2% isn’t crazy given the prospects for slow growth. And amen to the rest of the post, as a smarter than average guy in a field full of very high IQ people, chemical engineering, I saw a lot of hubris get a lot of smart guys in a lot of trouble.
I like this post, a good reminder to not get too cocky. I am still always trying to learn, and I think a great protection against this cockiness is to just keep building up the safety margin. That’s why I want to side hustle even though I don’t have to, it’s fun and it helps build my safety margin.
Absolutely Dave! Don’t get cocky!
I like to think that my “glass half empty” mentality will help compensate for any Dunning-Kruger effect I might have. I may think I’m better than I am, but I’ll always be worried about some disaster striking so it’ll hopefully even out 🙂
I think you’ve got plenty of mental competence to succeed at FI, but that’s where I do sometimes worry. What happens if you become incapacitated? I’ve also read that the apex of our overall mental capabilities is in our late 40’s (a blend of horsepower and acquired wisdom), so will I recognize it if I lose a step into my 50’s and beyond? Some of the old people who have been scammed or who have made colossal financial mistakes late in life were probably razor sharp when younger – that’s where training the missus and my kids will hopefully come into play.
Yeah, at some point my mental facilities are going to decline. How to identify when that is, is the main issue I think. 😉
This has given some food for thought. It is a good reminder also to not skew your impressions of your skills by comparing with the wrong group. For example, I would consider myself well-above average in knowledge of investing compared to the general population (let’s say in my home country of Australia), but in the FI community, I’m sure my knowledge would likely put me at average or below.
PS. Having just got my driver license, I don’t have to pretend at being a beginner there. I’m very much in tune right now with the mantra you mentioned: “I’m a bad driver, and if I don’t focus completely I’ll screw-up and hit something.” Oof.
Stay safe out there Michelle! Those car drivers are pretty crazy!
I think if you have the self awareness to ask the questions you are asking on this post you will do fine. You seem to ground yourself just fine.
At the end of the day the proof is in the pudding. If you have been successful at financial independence and continue to be successful then you have your answer. If you are a portfolio manager and can outperform the market year after year, then you are good. If you consistently underperform the market but yet think you are better than the average, then you are just fooling yourself.
Thanks for the comments Sport of Money! You’re right that the proof is in the pudding!
I like your plan and do similar calculations on my own wealth. I know, on some level, that the numbers bounced around in the financial independence community of saving up 25 times annual expenses or planning on a 4% safe withdrawal rate will probably work and most people will be able to retire comfortably with these amounts. I’ve seen the numbers and they are sound. And, I plan to keep working beyond this point. Like you, in my head, I use 2% as a safe withdrawal rate. When I reach this point, and have decades worth of my own actual data, I might rethink things. Today, 25x or 4% sounds too risky to me. In any case, safe is good, safer is even better, in my opinion. And one final point, I’m okay with my life today. I’m not doing anything I truly hate. You never know what tomorrow will bring. What if something happens tomorrow and my plans get derailed? Will I be far enough along my path to financial independence when it happens? There is no way to know. I’m simply doing the best I know how to do and hope, in the end, it is good enough. So, I approve of your plan, and thank you for the affirmation that I’m not the only one working a similar one.
If there’s one thing I’ve learned about life it’s that plans *always* get derailed. I’ve learned to keep flexible over the years, but damn if it isn’t frustrating! 🙂
When I learned to drive a motorcycle, the instructor shared some research that most riders get in accidents not right away but after several months because they start to get comfortable and lose that beginner’s mindset you mentioned. When I had kids, I stopped riding motorcycles because the data is pretty clear (damn it was fun though). You also mentioned your conservative position of holding extra cash (which I assume yields 1-2% itself). It’s worth noting that one of those years where you beat the market was 2018 right?
Ever so slightly yes. Partly because I held such a cash pile.
Given the long long bull run we have had till recently, I wonder how many people do indeed overestimate their ability to invest.
This can lead to overconfidence and bite them when the market will invariably turn.
I try to be conservative which I thought 3% planned withdrawal rate would qualify but going into the realm of 40x expenses might make it challenging for a lot of people if they do want to FIRE
Another side of this is analysis paralysis, or worrying so much that you never FIRE. My mind constantly runs through scenarios, not sure when I will feel safe enough
I think the tipping point for me was when my portfolio finally started earning more than I did on an average year. 😉
I’m trying to remind myself that I may not be as good as I think at certain things. Driving appears to be one of them, since I recently got into an accident. Turns out my reaction time isn’t as good as it used to be, so I was following a car too closely and rear-ended it when it stopped suddenly. No one was hurt, thank goodness, but like you I now drive more slowly and give more room between myself and the next car. Too much room, probably, but better safe than sorry (again).
Luckily (?) I *am* a beginner at investing, so I know that I know nada. For now I’m content to let the professionals at Vanguard handle my money. When life slows down a little (ha!) I can look into learning more about investing. Even so, I doubt I’ll ever feel like an expert.
And I regularly admit on my blog to my financial mistakes — or just choices that aren’t quite as frugal as I’d like — so I think I’m doing pretty well there at staying humble and realizing that I’m not nearly as good at finances as I want to think I am. So that’s something.
Woah 2.5%? I should probably lower my expectations from 4% too. Nuts.
My neighbor was going by 5% before I told him it should be 4% (not sure where he got 5% from) but I made his face sad since I just added a few more years of progress on their plans, blah.
“If you’re incompetent, you can’t know you’re incompetent”
I think some idiots know they’re incompetent, just ego hahaha. I remember 6 months into blogging I thought, “oh I got it allllll I know this.” Oh no…haha.
I agree with the mindset of not getting too cocky. But I’ve seen a trend lately of a lot of people getting more and more conservative with their withdraw rates. Of course nothing in life is a certainty. But I believe it was Mr. Money Mustache who espoused using even a 5% withdraw rate. If you’re living on a modest income from your portfolio, do you really think that if you’re the type of person to have accumulated 25x expenses it would be much of a problem to come up with an extra $10-$20K in income in a given year or for a couple of years just to bridge the gap if the markets get shaky for an extended stretch? Just a thought.