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On Investing and the Dunning-Kruger Effect

May 31, 2011 5:31 AM ET
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Seeking Alpha Analyst Since 2009

Born and raised in London, I have been trading and investing in financial markets for the past twenty years. My focus has been particularly on the interest rate markets and I formerly ran the fixed income group in London for a $20bn US hedge fund, trading 2% of all customer trades in the UK gilt market. Today I look for opportunities across all liquid markets globally.
On occasion it can be remarkably frustrating putting the case for an investment thesis to an unreceptive audience based on its intrinsic and rational merits.  Over time one perhaps learns that the approach one takes to forming an insight into likely prospective market developments is simply not compatible in the general case with the best way of persuading people of the correctness of that view.  Markets have their own intrinsic logic, and people have their own logic and the different logics do not play nicely together.  Indeed it could hardly be any other way, for were that to be the case we would see many more incidences of consistent investment success than we actually do see.

It is interesting how people do not generally seem to learn from their mistakes in the market.  If in July 2008 they listened to the hawkish rhetoric from the ECB and were swept up in the general climate of inflationary fear and as a result remained positive on inflation hedges and negative on European fixed income with unfortunate financial repercussions. then in May 2011 with perhaps a very similar setup it seems that they are quite content to make the same mistake.  And then as commodity prices correct, inflationary expectations ebb, and European fixed income rallies they say “well, the facts change”.  But the facts changed in an absolutely predictable, and predicted way that could be identified based on the initial conditions before the moment of hysteria started to exhaust itself due to natural forces.  And I wager that, once again, many commentators and economists will learn little from this experience, and what they learn will be the wrong thing.  But the world is so noisy, and our culture so unreflective and reactive that often being needlessly wrong has little adverse career impact.  In fact it is much better not to upset people with then-unconventional (and therefore unsound-seeming) ideas though they may yet become conventional wisdom with the passage of years; the path to success for most is to reinforce the audience’s self-esteem by uttering the conventional and acceptable platitudes and bromides of the time, paying lip-service to originality and the importance of recognizing reality, but without actually letting such a dangerous creature into the room.

In this context, I find it worth reminding oneself of the Dunning-Kruger effect

The Dunning–Kruger effect is a cognitive bias in which unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the metacognitive ability to appreciate their mistakes.[1] The unskilled therefore suffer from illusory superiority, rating their ability as above average, much higher than it actually is, while the highly skilled underrate their own abilities, suffering from illusory inferiority. Actual competence may weaken self-confidence, as competent individuals may falsely assume that others have an equivalent understanding. As Kruger and Dunning conclude, “the miscalibration of the incompetent stems from an error about the self, whereas the miscalibration of the highly competent stems from an error about others”

Perhaps one must therefore adopt the rules appropriate to the domain one is working in.  Form one’s market view based on relevant considerations; communicate it informed by the rules developed by authors of antiquity.  And reserve most conversations about the nitty gritty behind the view for the elect who have proven their competence and discernment in previous interactions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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