Originally published here
By Callie Cox, senior investment strategist for Ally Invest
Stocks have calmed down over the past few weeks as temperatures rise and trading volumes drop. But just because markets are on a little spring break doesn’t mean you have to be.
Quiet periods are the perfect time to strengthen your mental game. A lot of investing is about controlling your emotions and biases, believe it or not. And let’s face it: Hubris seems to be at an all-time high these days, along with prices in most markets.
This week, we’ll look at the Dunning-Kruger Effect and how an imbalance of competency to confidence could sabotage your investing success.
The Dunning-Kruger Effect is a cognitive bias in which people overestimate their competency and underestimate other catalysts, such as luck, for an outcome. It’s basically the psychology behind the saying “check yourself before you wreck yourself.”
There’s a relationship between competency and confidence, too. A little knowledge can lead to a lot of confidence until you realize how much you don’t know about a certain subject.
Psychologists David Dunning and Justin Kruger identified the bias in 1999, citing a now infamous example of a bank robber named McArthur Wheeler. Wheeler covered his face in lemon juice during a robbery, thinking it’d make him invisible to security cameras. Guess what? Lemon juice may work on paper as invisible ink, but it doesn’t make humans disappear on camera. Wheeler overestimated his competency, and ironically, his blind spot was the reason he got caught.
Competency and Confidence
While I doubt any of you are smearing lemon juice on your face to rob banks, Dunning-Kruger can pop up in other areas of your life. It’s that coworker who thinks they know everything or that distant relative who tells you how to manage your love life.
Dunning-Kruger can also exist in investing. Competence and confidence have played a part in some of the biggest market events in history, for better or for worse. The Great Financial Crisis was a blow to investors’ confidence, and it kept many of them out of the market for years. But in 2020, we saw millennials and younger investors confidently step in and buy during the COVID dip, armed with the memories of an 11-year bull market in which stock prices more than quadrupled without a 20% drop.
Today, we’re in the throes of a strong market, and Dunning-Kruger is out in full force. We all have those friends who have bragged about their returns from that hot stock or random Dogecoin stake. Making money is great, but did you profit from skill or luck? And more importantly, are you able to sell your holdings without the fear of missing out or losing it all before you can get out?
It’s important to stay grounded (and humble) to keep yourself from getting burned if the market turns.
Here’s how you can keep your Dunning-Kruger in check.
Know your competence. Part of checking your ego requires figuring out what you know and don’t know about your investments.
Even the smartest investors know their strengths and weaknesses. Warren Buffett and Charlie Munger of Berkshire Hathaway fame have talked about following the “circle of competence” theory, or the exercise of investing in names and sectors you know the most about.
The solution? Be honest with yourself: What are your areas of expertise, and what are your blind spots? It can be an uncomfortable evaluation, but knowing your limits can help you identify what part of the market you should focus your attention on most.
And remember: “Check yourself before you wreck yourself” does not mean stay out of the game completely. Everybody can be an investor. Stay engaged, and don’t psych yourself out.
Acknowledge change. If you own stocks, chances are you’ve done well over the past year. The stock market just posted its best 12 months in recent history, with the S&P 500 notching 18.4% in 2020 (including dividends). Long-term Treasuries, a historically more conservative market, gained 17.7% in 2020. U.S. housing prices jumped 10%. Even gold soared 25%.
It was an unusually good year across the board. In fact, stocks and bonds haven’t gained 15% in the same year since 1997.
But markets can change quickly, and things that work today may not work tomorrow. Just look at this chart of best-performing asset classes since 2001:
You’ll notice that different investments top the chart as time goes on, depending on economic conditions, political events, regulatory changes and unforeseen events. This goes for sectors, too. Tech, for example, has been one of the hottest industries post-COVID, but it’s only led the market higher in three out of the past 10 years.
The solution? Don’t be afraid to tweak your portfolio. When one market has done especially well, it could be a good idea to take some money out of that hot market and put it into another asset class. That’s called rebalancing, and it helps keep your portfolio in line with your goals instead of over-exposed to the fortune of one market.
Check your confidence. Examining your Dunning-Kruger bias isn’t just about knowing your competencies. It’s about checking your confidence, too. Overconfidence is a common (and somewhat glamorized) trait on Wall Street, but it’s a dangerous mindset that could make you blind to the risks you’re taking. Market history is littered with investors whose portfolios blew up from risky, leveraged bets (the most recent victim being Archegos Capital).
A lack of confidence can be a huge barrier, too. About 45% of consumers don’t feel confident in their investing and saving options, according to an Ally survey. When you don’t feel empowered, you may miss opportunities to grow your portfolio even if you have the knowledge to do so. Or worse, you may not invest at all.
The solution? Remember to identify your strengths and weaknesses, because being aware of areas you may not be as skilled in yet is a strength in itself. Staying engaged and being a lifelong student of the markets can be an antidote to Dunning-Kruger.
Nobody has totally figured investing out yet. That’s the fun part. And as you study, you may realize a passion for investing that you never knew you had. Know that it’s normal to feel your confidence slipping as you learn, because eventually, more knowledge can equal grounded confidence and more power.
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