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Sunday, 7 June 2009

Don't Lose Money in the Stupid Corner

The Dunning-Kruger Effect

Justin Kruger and David Dunning have conducted some excellent research into incompetence, providing invaluable pointers for investors who don’t want to waste their lives following up dead-end leads and engaging in pointless debates. What they discovered is not just that the incompetent are, well, incompetent but that they’re so bloody stupid that don’t know that they’re completely useless.

In fact, sometimes they’re so dumb they can’t even tell when someone else is more knowledgeable than them. Think Forrest Gump debating quantum mechanics with Albert Einstein. Only one winner there, in Forrest’s eyes.

Inflated Self Assessments

Kruger and Dunning’s research is entitled: Unskilled and Unaware of It: How Difficulties in Recognising One’s Own Incompetence Lead to Inflated Self-Assessments. Anyone who spends any social time on investment activities will probably recognise someone from that description. If you don’t perhaps it’s time to take a good hard look in the mirror...

The research in question is an extension to the overconfidence biases often exhibited by people in a wide range of disciplines. It turns out that some people aren’t just normally overconfident but that their self-image is so out of kilter with reality that it brings into question their ability to provide useful analysis of pretty much anything. Basically they’re unbelievably bad and don’t know it, taking the concept of overconfidence to a whole new (low) level.

Mega-bad at Meta-cognition

What Dunning and Kruger showed was that there’s a subset of people who are especially poor at assessing their own abilities – meta-cognition, in the jargon – over and above normal issues of overconfidence and over-optimism. Although nearly everyone overestimates their ability a bit – they roughly think they’re about 6% better than they actually are – the serially stupid do so to a massive extent – of the order of 60%: they think they're good when they're really rubbish.

The problem seems to be that these people are so bad they have no way of gauging their own level of competence in comparison with everyone else. Worse still, if you’re really bad at assessing your own ability you’re likely to be really bad at assessing someone else’s. When Kruger and Dunning conducted a set of experiments on the topic this is exactly what they found – the most incompetent people are unable to recognise truly competent people when they meet them.

To make it even worse, if that were possible, the truly incompetent never learn. No matter how much feedback they received they never get any better. It turns out they can’t understand the feedback. Well, duh.

Broadcasting Financial Incompetence

Although some individuals are serially useless it generally seems to be domain specific. You can be terrible at spelling and brilliant at maths. And you can be superb at socialising but a bloody awful investor. Unfortunately there are some people who will never be able to make sensible investment decisions yet will delude themselves quite happily that they’re ace investors. These people will argue that Growth is the new Value with people who’ve made millions and never waiver in the belief that they’re right.

Presumably a lot of people simply get on with losing money in private without bothering the rest of the world with their opinions. Unfortunately some of them feel obliged to give voice to their beliefs and, such is the way of the world, some of them get taken notice of. If you’re inclined to take any interest in other people’s views – and being social creatures we often do – it’s as well to recognise the signs of the serially ignorant and take evasive action. The only alternative is premeditated homicide.

For once the investment industry comes out of this reasonably well – not even the financial business sector can cope with large quantities of complete incompetents managing their activities. However, wherever you find financial punditry you’ll find traces of the monomania that possesses the know-nothings of this world. It’s bad enough with the traditional press but, now we have the disorienting and disintermediating effect of the internet to cope with, they can get everywhere.

Bulletin Boards Bozos

In the name of research I spend a few minutes a week browsing various websites and reading the financial press. I don’t enjoy this, of course, except in a vicarious way. On bulletin boards you’ll often find puzzled posters desperately attempting to reason with someone whose logic isn’t so much flawed as diametrically opposed to the basic physical laws governing the universe. People who are bulls in the morning, bears in the afternoon and, presumably, cross-dressers in the evening.

The incompetence of this group makes them unsuited to engage in investing activities for themselves but their inability to recognise that they’re incompetent makes them dangerous in the presence of others. As they can’t actually recognise someone who is capable it’s completely pointless pointing out that they’re wrong. They simply have no way of correcting their own behaviour – you might as well discuss algebra with a sponge.

It’s important to realise that these people aren’t being deliberately disruptive or stupid. They genuinely believe that they’re bringing insight and illumination to the masses. They’re trying to help us. Sadly it’s like the blind leading the sighted, only the blind don’t realise they can’t see and the sighted have been bamboozled into believing they’re missing something important. It’s another form of the Tragedy of the Commons, as perfectly fine investment forums are destroyed by bozos.

Media Muppets

It’d be comforting to think that such incompetence is confined to the electronic nether regions of the Internet but the evidence suggests that it isn’t. An awful lot of financial reportage is poorly researched, regurgitated output from companies and fund managers. Much of the rest of the media’s commentary on investment topics appears to operate on the same basis as the short-term memory of a goldfish, with writers ignoring advice and recommendations given only weeks or sometimes days earlier. Either these people are utterly incompetent or they have no shame. Hmm ...

To be fair, the best financial journalists are pretty good even if they’re forced into the equivalent of making up horoscopes for the markets. Where it gets really bad is when there’s some financial crisis and the feature writers start to opine on the markets. When investing hits the front page you can be pretty sure investment logic’s gone out the window and the serially stupid are on the loose with unsubstantiated opinions on pretty much everything.

Trashy Tipsters

The most dangerous group of incompetents of all are the pundits, the authors of tipsheets and the like. Frankly if these people were any good at investing they’d be making stacks of money by doing so, not trying to con it out of other people. They may be good at marketing but the best of them are barely average investors and the worst stand shoulder to shoulder with the dumbest of the dumb.

In the words of Graham and Harvey:
"In our study, overall newsletter market-timing ability is so poor that we cannot identify superior absolute performance".
In fact about the only way of making real money from them is to find the very worst ones – the truly incompetent – and then to do exactly the opposite of what they recommend. These people are so bad it’s unbelievable.

Barmy Bloggers

Finally, of course, I should reserve opinion on my own medium. There are many fine financial blogs doing a valuable service in independent analysis and commentary. Sadly there are also many whose main purpose in life is to present the blogger’s views as fact: beware unresearched assertions – even here. Always remember that you may invest with company but you’ll always end up losing money alone. In the words of Charles Darwin, who knew a thing or two about unsubstantiated opinions:
“Ignorance more frequently begets confidence than does knowledge”.
Self-Insight: Roadblocks and Detours on the Path to Knowing Thyself (Essays in Social Psychology)RISK: THE SCIENCE AND POLITICS OF FEARCapital Ideas: The Improbable Origins of Modern Wall Street

Related Articles: Overconfidence and Over Optimism, The Tragedy of the Financial Commons


Aimee said...

Good article, but please provide a solution. Who are "[the] many fine financial blogs doing a valuable service in independent analysis and commentary"?

timarr said...

Hi Aimee

Mea culpa. I guess I was relying on the law of averages :-/ I do believe that the future of media lies in disintermediating the mainstream but I have no idea how we connect the interested consumer with the interesting producer. However, to give a flavour of what I hope for, but on a rather different subject, take a look at

Anonymous said...

Terrific article. If only some self-styled financial bloggers with 'ground breaking research overturning decades of bad advice' would have the mental capability to read and understand the implications!

Alas, the article tells us what to expect in that regard: the clueless do not know they are clueless, so therefore will never admit it. Those of us who are at least partially competent spend a LOT of time second guessing, checking, doubting, refining, and then doubting again. If you are sure that you, and only you, has the answer that everyone else is failing to see, there is indeed a chance you are an unappreciated genius. Much more likely, though, you are just a self-deluded dolt.

Nature Creek Farm said...

Perhaps simply being smart enough to understand that financial markets are random data imprinted with marketing coercion would dispel much of the hype about investing. The more one understands, the less they would participate in the poker game of modern investing (unless they have enough money to control their part of the market).
As a counterpoint to the stupid overestimating their competence, I think that the extreme opposite end underestimates their ability to apply rigorous thought, and they often find that deep investigation of human behaviors conflicts so much with natural law that they just simply ignore the evidence. Once you understand the randomness (nod to Taleb) of the universe and the usefulness of life, you may just decide humans have negative value: and that wouldn't be a 'good' mental attitude to share with others... ;-)