Investing and the Dunning-Kruger effect. 4 essential stages of competence

In economic theory, it was initially believed that rationality and detached calculation were the driving forces behind human behavior. However, as we now understand, this assumption is not entirely true – we are already well aware that most of our decisions are based on emotions. In business, there is much talk about psychological mechanisms that affect the way people behave. One of them is the so-called Dunning-Kruger effect, which can lead to unhealthy thinking patterns. How can you fight it to avoid losing your money? Read on to find out more.

What is the Dunning-Kruger effect?

The Dunning-Kruger effect is a concept from behavioral economics that we deal with when making investment, purchasing, and financial decisions. This cognitive error indicates that people with little experience and knowledge in a given field overestimate their abilities. The phenomenon also works the other way round – specialists or experts tend to undervalue their skills and often think their knowledge is incomplete.

Four stages of competence

• Unconscious incompetence

At this stage, you don’t see the need to acquire new skills and you have too much self-confidence. This is where you experience the Dunning-Kruger effect that reveals the tendency to unrealistically evaluate your abilities.

• Conscious incompetence

This is the moment when you start to notice that you lack certain knowledge when compared to others. Therefore, you decide to learn new skills. Initially, you make many mistakes, which may reduce your motivation, but keep in mind that these are only temporary difficulties.

• Conscious competence

At this stage, you already know what you can do, and what aspects still need improvement and work. You gain knowledge and look for opportunities to put it into practice.

• Unconscious competence

As you get more experience, certain tasks become easy and you do them almost automatically. However, you are well aware that you should still develop, train yourself, and at a later stage, share your knowledge with others.

Examples of the Dunning-Kruger effect

Let’s take a closer look at the examples of the Dunning-Kruger effect:

• The conviction that you possess greater knowledge and experience than others, and thus your decisions are right,
• Improper calibration – overconfident investors tend to overestimate their ability to evaluate the situation accurately, and thus incorrectly assess the probability of stock price movements,
• Unjustified confidence as to the success on the stock market, despite the negative signals – being driven by emotions rather than common sense,
• Taking investment risks without getting the bigger picture and exposing yourself to financial losses,
• Overtrading – excessive buying or selling stocks, which generates costs and often leads to poor financial decisions,
• Ignoring the bigger picture, which makes it impossible to gather all the necessary information to objectively assess the market situation and can result in losses,
• Seeing patterns where they don’t exist,
• Selling loss-making assets reluctantly, hoping that the situation will change.

It is crucial to acknowledge that this phenomenon can have negative consequences for your company, such as hiring insufficiently qualified candidates, conflicts between employees, lower work efficiency, and worsening business relations with contractors.

How to combat the Dunning-Kruger effect?

Certainly, the first and key step to combating the Dunning-Kruger effect is to understand that most of our decisions are based on emotions and fixed patterns. Noticing this will let you look at your behavior objectively and rationalize your thought processes. What else can you do to reduce the negative impact of the Dunning-Kruger effect on your investment decisions?

1. Ask yourself a few questions:
• Why will buying/selling this stock be beneficial, and is this decision in line with my investment objectives?
• How long have you been interested in the stock market and investing? Do you feel you have sufficient experience?
• How extensive is your knowledge of economics and the stock market? How much time have you spent and do you currently spend on studying and analyzing trends?
• Have you suffered large financial losses in the past as a result of poor decisions?
2. Improve your critical thinking skills.
3. Acquire and regularly update your knowledge. Stay abreast of news from your industry, and enhance your skills.
4. Avoid speculative bubbles and leverage if your business is not profitable enough to repay its debts.
5. Monitor all the transactions you make so that you have control over them and can review them periodically. Make sure that the fees associated with these transactions do not outweigh the financial gains. These transactions can provide valuable information and guidance for the future.
6. Get advice from a financial expert. Their opinion will help you look at your situation from a different angle.
7. Conduct a simple SWOT analysis. Becoming aware of your strengths and weaknesses, opportunities and threats will let you objectively look at your capabilities as an investor and as an entrepreneur.
8. Don’t be afraid to admit you are wrong.
9. Diversify your investment portfolio – combine riskier financial instruments (e.g. stocks) with the safer ones (e.g., bonds, deposits). You can also use derivative financial instruments like forwards, futures, options, and swaps.
10. Practice investing using a stock market simulator to test your strategies without risking losing cash. Learn the specifics of market mechanisms and gain experience.
11. Use the stop-loss order, which will let you sell a stock when its price reaches a certain level.

Summary

Being excessively confident when making financial decisions is a trap. The Dunning-Kruger effect can result in a substantial financial loss, regardless of whether you are budgeting for your company, making a big investment, or saving money. That’s why it’s crucial to understand the mechanisms and nuances of human behavior when it comes to managing finances.

Read also: What is a Laffer Curve?

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