Recognising your investment limitations is a financial superpower

In 1995, a man called McArthur Wheeler walked into two Pittsburgh banks and robbed them in broad daylight. He made no attempt at disguise, which hastened his arrest later that day after recordings of him taken from surveillance cameras were broadcast on the 11 o'clock news. When arrested he was incredulous, telling the police “But I wore the juice”. He was under the impression that rubbing one's face with lemon juice rendered it invisible to video cameras . 

A psychologist by the name of David Dunning read about the case and thought the incompetence was so profound that it was worth studying. The thing about McArthur Wheeler was not just that he was an incompetent bank robber. It was that he had no idea that he was an incompetent bank robber. Alongside becoming a convict, McArthur Wheeler was to become a minor legend in behavioural science as the inspiration for what later became known as the Dunning Kruger (DK) effect.  

Ignorance begets confidence

When people are incompetent they suffer a dual burden: not only do they reach mistaken conclusions and make unfortunate choices, but their incompetence robs them of the ability to realise it. Like Mr. Wheeler, they are left with the mistaken impression that they are doing just fine. As Charles Darwin sagely noted over a century ago, “ignorance more frequently begets confidence than does knowledge”.

David Dunning together with another psychologist Justin Kruger wrote up their research findings in a 1999 paper. The DK effect describes a common truth about the way we think – we all lack self-insight some of the time and in particular when we stray beyond our sphere of competence. And we may lack the competence to know it. 

To the extent that you are reading this and thinking, as I did, that this applies to hapless fools, and so I must be immune. Unfortunately, DK isn’t just about stupid people doing stupid things. It’s about clever people doing stupid things too.  

Clever people do stupid things also

You may not think that lemon juice makes you invisible to cameras. But according to David Dunning, in a whole battery of studies he and others have conducted, it was found that people who don’t know much about a given set of cognitive, technical, or social skills tend to grossly overestimate their prowess and performance. Whether it’s grammar, logical reasoning, debating, or financial knowledge, the effect covers a multitude of domains. 

The DK effect is about blind spots. And as with all blind spots, the brain just fills in the gap – we don’t perceive them as blind spots – we don’t perceive them at all.

In the last few weeks, an implosion of a little-known hedge fund called Archegos serves as an expensive reminder of this. 

The case of the Archegos Hedge Fund

Bill Hwang, an alumnus of famed hedge fund Tiger Management, took around $200 million in 2013 and turned it into a $20 billion net worth by betting successfully on technology stocks. He then lost it all in two days in March as his Archegos investment fund imploded. His fund at some point strayed beyond technology stocks, and together with high leverage and intense concentration, it suffered catastrophic losses. Hwang's leverage was engaged through swaps that concealed the true extent of his positions from the those that were lending him money. The blow-up then led to major losses for a number of investment banks that facilitated his trades . 

Bill Hwang is no McArthur Wheeler, but they’re both members of the Dunning Kruger club. 

Dunning Kruger and the stock market

The first rule of the DK club, is that you don’t know you are a member. And while we are all members, we drop in and out of the club as we stray across the threshold of competence. A bit like Wile E. Coyote who races off the cliff edge – it can take a while before we realise we are not on solid ground. Unfortunately for Hwang and anyone else involved in financial markets, they provide very fertile ground in which unearned confidence can flourish. 

A surging stock market is thrilling. This excitement comes not only from rising share prices but from the vindication of ‘knowing’ your investments were a wise decision. As the old adage goes, don’t confuse a bull market with brains. The line of causation between investment decisions and results over the short term is extremely blurred. A very lucky decision is indistinguishable from a very skilled one in the short term. But both equally feed confidence in our decision-making prowess. 

Ask for advice

There is a cure. It’s to ask for advice. But to seek advice first requires us to doubt our own reasoning. We don’t know what we don’t know. 

Even if you think you are extremely capable, in fact especially if you think this, then you should seek external guidance. Recognising your limitations as far as your finances go is a superpower of sorts.

We make enough mistakes by accident. Try not to make one on purpose. When it comes to investing, ask for advice.