Image Credit: Christophe Vorlet
By Jason Zweig | Dec. 1, 2017 12:12 pm ET
The gravity-defying rise of bitcoin has been drawing in new money from people who appear to know nothing about the cryptocurrency other than the fact that its price has gone up a lot in a hurry.
On Nov. 30 the fifth-most popular stock among brokerage customers of Fidelity Investments was Bitcoin Investment Trust, an unregistered fund that holds bitcoin. It traded that day at a price almost 70% higher than that of the digital currency itself, points out Nicholas Colas, co-founder of DataTrek Research. Even at that price, buyers outnumbered sellers at Fidelity by more than 40%.
This sort of speculation is a reminder of a metaphor Warren Buffett and his business partner Charlie Munger like to use: the circle of competence.
The diameter of the circle you can draw around your knowledge doesn’t matter much. It’s okay to know a lot about only a little; it’s even okay to know next to nothing, so long as you realize it.
What does matter is accurately assessing where your ignorance begins and not fooling yourself into thinking that you know more than you do.
Consider a recent nationwide survey by the Pew Charitable Trusts. Among more than 1,900 people saving for retirement, 68% said they were at least somewhat familiar with the fees their plan charges. However, only 25% had read and understood their retirement plan’s disclosures about fees.
That’s the tip of the iceberg of ignorance.
In a just-published study based on responses from more than 5,800 LinkedIn members in 2014, finance professors Anders Anderson of the Stockholm School of Economics and David Robinson of Duke University asked basic questions testing how much people knew about investing and personal finance.
Among them: “Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account?”
(The correct answer: “Less than today.”)
Only 38% of those surveyed got all five questions correct. Worse, more than one-third of chief executives, chief financial officers and chief operating officers didn’t get all the answers right.
Worse still: The study asked people to estimate how likely their answers were to be correct. Those who got no more than two of the answers right estimated, on average, that they had gotten 2.5 correct. Many who got none right thought they had nailed every question.
“People who lack financial literacy are just as likely to be sure of themselves as those with high financial literacy, but their confidence is likely to be unfounded,” says Prof. Robinson.
Investors who overestimate their knowledge are more likely to agree with the false belief that past performance is more important than fees in predicting the future returns of a mutual fund.
David Dunning, a psychologist at the University of Michigan, isn’t surprised. He is the co-author of research on what has become known as the Dunning-Kruger effect: the state of being ignorant of your own ignorance.
That seems to be a fundamental part of what it means to be human. “We don’t have an index or catalog in our heads that says, ‘You know this, you don’t know that,’” says Prof. Dunning. “So we’re left to guess.”
Sometimes, when you have precise feedback, those guesses are good: Thanks to stopwatches and bathroom scales, you probably know quite accurately how fast you can run a mile or what you weigh.
Let’s say, though, that you buy a stock at $10, and it promptly falls to $9.50: You were wrong! Then it rises to $10.50: You are right! In the financial markets, feedback can be in constant flux.
As a result, investors can fall into what Prof. Dunning calls “the beginner’s bubble.” New to the task, “they over-read the significance of the first few successes they have,” he says. “They base their ideas of their competence on much too little experience.” Not recognizing that they shouldn’t draw sweeping conclusions from only a handful of outcomes, “they think they got it right immediately.”
A quick hot streak can give beginning investors a jolt of confidence unwarranted by the evidence.
A recent study in the Journal of Chemical Education found that students got much higher exam scores if they first took repeated practice tests, systematically estimating how they would do on each.
Investors can do the same: Before risking real money, create a play portfolio in which you execute and record hypothetical trades. Estimate how well each will do and how confident you are in those estimates.
If you find you consistently overstate how well your bets would pay off, you have no business making bets.
Source: The Wall Street Journal, http://on.wsj.com/2i8yAYa
For further reading:
Jason Zweig, Your Money and Your Brain
Jason Zweig, The Devil’s Financial Dictionary
Anders Anderson and David T. Robinson, “Self-Awareness, Financial Advice and Retirement Savings Decisions”
Anders Anderson et al., “Precautionary Savings, Retirement Planning and Misperceptions of Financial Literacy”
Carmen Sanchez and David Dunning, “Overconfidence Among Beginners: Is a Little Learning a Dangerous Thing?”
David Dunning, “The Dunning-Kruger Effect: On Being Ignorant of One’s Own Ignorance”