In the world of investing, what you don't know can hurt you. But it's when you aren't even aware that you don't know something that things can get really bad.
After the 2008-2009 financial crisis, the Financial Industry Regulatory Authority and the U.S Treasury set out to study how much people knew (or thought they knew) about investing and finance. They ran a survey in which people rated themselves on their financial knowledge. They then had respondents take a test to see how much they actually knew about finance.
Of the 25,000 people surveyed, 800 had previously filed for bankruptcy protection. This group didn't do very well on the test and they finished in the bottom half. But even though this group performed poorly, the same group -- people who had failed the most basic personal finance test of income being greater than expenses -- on average believed that their understanding of finance was better than others.
The Dunning-Kruger effect is when people think they're smarter than they really are. (It's named after the Cornell University psychologists who first officially observed it.)
One of the two researchers, David Dunning, found that the main reason for this tendency was ignorance -- and not arrogance. When people know little about something, they tend to not even realize how much they don't know. As a result, they aren't able to accurately assess their own abilities.
(We're written about this investment pitfall -- when investors let their emotions get in the way -- and a number of others in a free report available here.)
Dunning also discovered that the least skilled people are the ones who are most likely to overestimate their abilities.
Investors similarly sometimes think they know more than they do. They think that having access to lots of information, data and figures equates to having real insight. The media compound this problem by turning complex research into one simple conclusion (buy! buy! buy! ... and, very occasionally, "hold").
Access to gigabytes of information and the media's tendency to oversimplify can cause us to think we know more than we really do.
To avoid the Dunning-Kruger effect, you need to be honest with yourself about your abilities. Do your homework and exchange ideas with your peers. The more we learn, the more we realize just how little we really know. This helps keep us grounded -- and can help us make more informed decisions.
Former U.S. Secretary of Defense Donald Rumsfeld once 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."
To be an effective investor, it is critical to be self-aware and understand your unknown unknowns.
Kim Iskyan is the founder of Truewealth Publishing, an independent investment research company based in Singapore. Click here to sign up to receive the Truewealth Asian Investment Daily in your inbox every day, for free.
We've also put together a free special report with more about how to avoid losing money because of the Dunning-Kruger effect, along with a number of other cognitive biases... to receive it, please click here.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.