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”
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.
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.”
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]