Dunning-Kruger effect

The Dunning-Kruger effect describes the cognitive bias whereby people with little knowledge systematically overestimate their abilities.

The 4 phases:

• Phase 1 – unconscious incompetence: "I don't know what I don't know"
• Phase 2 – "Mount Stupid": a little knowledge, maximum self-confidence. "Shares? Easy, I'll watch a few videos"
• Phase 3 – "valley of despair": first losses, realisation of how complex everything is
• Phase 4 – conscious competence: real knowledge built up, realistic self-assessment

Dunning-Kruger in finance:

• Day trading beginners: after 3 successful trades they think they've "understood the market"
• Crypto hype: newcomers who bought Bitcoin at $60,000 in 2021 because "it can only go up"
• Finfluencers: 22-year-olds with "financial expert" in their bio after 2 years on the stock market
• Hedge fund managers: even professionals with 20 years' experience mostly don't beat the index

Remedy:

• Humility: the most important investors (Buffett, Bogle, Sharpe) recommend simple ETF portfolios
• Track record: write down your trades – most "geniuses" lose over 1+ years
• Checklist: before you invest: "What exactly do I know that the market doesn't?" (Answer: usually nothing)
• Index funds: accept the market average – that way you beat 90% of professionals