How Not to Invest: The ideas, numbers, and behavior that destroy wealth—and how to avoid them

by Barry Ritholtz

I discussed the concept of hypothetical bias with the Cal-Tech professor.367 When scientists ask hypothetical questions—“Will you vote in this election?”—about 70% of study participants answer affirmatively. However, people’s real-life behavior differs dramatically from how they answer: Only around 45% of the people in the study actually voted. In races where a 1%-point swing can determine an election, a 25% difference between intention and behavior is massive. No wonder political pollsters keep getting their projections so wrong.

Hypothetical bias

How good are you at evaluating your own skills? As it turns out, not very. Called “metacognition,” the Dunning-Kruger effect is why you think you are better at this than you really are.

Metacognition

David Dunning is a Professor of Psychology at the University of Michigan371 who studies human understanding. In 1999, he and Justin Kruger, a graduate student, published an in-depth study of how people, regardless of their expertise, evaluate their own skills. Titled “Unskilled and Unaware of It,”372 their study found that people with limited competence in a specific area overestimated their abilities in that area. Metacognition, it turns out, is a discrete skill unto itself. It tends to increase as your skill in the underlying domain increases. As you improve at a thing, your ability to evaluate your skills at that thing also improves.

DK effect

Or you may prefer Shakespeare’s take in As You Like It: “The fool doth think he is wise, but the wise man, knows himself to be a fool.”

Wise man And the fool

When they venture outside their field into other areas, the risks of being wrong increase—this is called “epistemic trespass.”

Epistemic trespass

Smart people can suffer from deformation professionnelle (“occupational deformity”)—a DKE-related tendency to view the world through the lens of one’s own profession.380 It’s not surprising that a mathematician looks at a psychological phenomenon and sees only the statistics. Performing statistical analysis on psychology research while unaware of decades of underlying research in psychology sounds a lot like the Dunning-Kruger effect at work.

Deformtion profesionalle

Nobel Prize-winning physicist Richard Feynman suggested, “If you want to master something, teach it.” (He also observed, “I learned very early the difference between knowing the name of something and knowing something.”)

Feynman ~ teach it

Physicist Carl Sagan once observed, “Extraordinary claims require extraordinary evidence.” Be wary of your tribal beliefs.

Extraordinary claims

Rudyard Kipling advised his son: If you can keep your head when all about you Are losing theirs and blaming it on you, If you can trust yourself when all men doubt you, But make allowance for their doubting too; Yours is the Earth and everything that’s in it! That’s good advice for all of us…

Kipling

Or, as Blaise Pascal, the French mathematician and philosopher, once observed, “All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”

All of humanity's problems

And yet, the lure remains. For too many investors, it’s “Come for the high fees, stay for the underperformance.”

Fees + underperformance