Financial Geekery

The Dunning-Kruger Effect and the Engineer Syllogism

December 30, 2018

Credit: xkcd.com

 

I've seen it happen time and time again. Smart people -- particularly tech professionals -- fall victim to their own cognitive bias, in no small part because they believe they don't have any. I discuss overconfidence in my post on cognitive bias, but it's worth talking about in a little more detail, because we engineers tend to fall to a particularly pernicious form of overconfidence due to the Dunning-Kruger Effect.

 

What's the Dunning-Kruger Effect?

 

It's pretty easy to intuit Dunning-Kruger from the following graph.

 

Credit: catalogofbias.org 

 

Makes sense, right? When you first start gaining experience in a matter, your confidence shoots up to the point that you far surpass that of an expert (not to mention your own actual ability). As you start to learn what you didn't know you didn't know, your confidence goes down. Once you have reliable expertise, your confidence goes up again -- but this time, it's because you actually know what you're doing.

 

(For the longest time, I personally wondered why I had an innate distrust of people who exhibited high confidence levels. Once I learn about the Dunning-Kruger effect, I finally understood why!)

 

But that's not me -- I'm on the right side of the curve!

 

And this is where engineers fall into the trap. Because we're good at engineering, math, and analysis, we assume that we're good at financial planning, and particularly investments. In actuality, we're on the left-hand side of the curve where those things are concerned, because we vastly, vastly underestimate how complex the market system is.

 

As Dunning himself said, "The skills you need to produce a right answer are exactly the skills you need to recognize what a right answer is." Any research-based investment advisor will tell you that recognizing a "right answer" where the market is concerned involves slicing up decades of data in every possible way to determine whether a strategy is "persistent, pervasive, robust, investable, and explainable". That's not something you're going to do with a spreadsheet and Google Finance!

 

But because we don't know what we don't know where investments are concerned, we fool ourselves into thinking that a little Excel magic will let us predict where any given security is going on any given day. I've spoken with engineers who day-traded their 401(k)'s during the 90's tech run-up. They couldn't lose...until they did, and lost big. Not quite a decade later, the same thing happened prior to the Great Recession. (Side note: a decently diversified portfolio would have actually gained money during the tech bust. Not so with the Great Recession, but diversification isn't a panacea.)

 

Dunning-Kruger also makes it easy for us to fall into the trap of "investing in what we know". We somehow think that because we work for a good company with smart executives and hard-working employees, that means our company is a good buy. Even worse, we may simply want to invest in our company because we've been given stock as part of our incentive, and it just "keeps going up"! With apologies to corporate benefits teams: please diversify out of your company's stock! Your income is already strongly tied to your employer's financial well-being; there's no need to double down and putting a large chunk of your investments there, as well!

 

What can you do about Dunning-Kruger?

 

Simply being aware of the Dunning-Kruger effect will help you tremendously. For example: if you hear someone boasting about how they made a lot of money using options, hopefully you'll be less inclined to go off and do the same, knowing that they could have gotten lucky and, being on the left side of the curve, not known the difference between luck and skill.

 

Be wary of Internet forums, for similar reasons. Some forums are just text versions of cocktails parties, but I've found that even the vaunted Bogleheads will often oversimplify, not likely due to lack of knowledge, but simply because books don't fit into forum posts!

 

If you're looking to "move toward the right side of the curve" yourself, I'd begin with some good books. I recommend anything by Larry Swedroe or William J. Bernstein to start; they an academic approach that doesn't try to distract you with the latest "shiny things" and get-rich-quick schemes. Once you've got the basics down, you can look for papers, especially by researchers like Eugene Fama and Kenneth French. Alternately, there are many local and online educational institutions that teach CFP-level investment classes, which is a little more expensive but gives you the opportunity to ask specific questions of the teacher.

 

Of course, while this will teach you the theory, you won't get a lot on the ins and outs of limit orders, rebalancing, tax-loss harvesting, wash sales, etc. Your main options there are (a) going to work for an investment advisor who'll give you training, or (b) learning by trial-and-error, with your own money. 

 

What if you've decided you're not interested in fully optimizing investments on your own? Can't you just hire a financial advisor? Definitely! That said, it's important to know enough to ask the right questions. Otherwise, you might hire a financial advisor with the best of intentions...who themselves is suffering from Dunning-Kruger!

 

You don't necessarily have to buy books and take classes per above, but the right education can get you quite far. This is one of the most important financial choices you can make -- it's worth your while to put some effort into learning about it! In addition to learning the basics about what a financial advisor is and how to find a good one, it's worthwhile to know the theory behind smart investing and outperformance, so when you ask them what their investment philosophy is, you can evaluate the answer!

 

This lets you take a middle-ground approach: knowing enough to find a good investment manager, ask them good questions, and guide them effectively, without having to basically take on another job. This in turn allows you to focus on your optimal path to wealth: by moving to the right side of the Dunning-Kruger curve related to your chosen career, you can maximize your earning potential, which has its own compounding effect on your investments!

 

 

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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