Dunning-Kruger Effect: Meaning and Examples in Finance

What Is the Dunning-Kruger Effect?

The Dunning-Kruger Effect is a cognitive bias first described by psychologists David Dunning and Justin Kruger in 1999. It occurs when people with low levels of knowledge, skill, or competence in a particular field overestimate their own ability and knowledge.

Put differently, people who don’t know what they’re talking about tend to (incorrectly) think they do know what they’re talking about. At the same time, experts in a field may underestimate their own knowledge and competence. This part of why Dunning and Kruger’s findings are similar to imposter syndrome, whereby high achievers begin to doubt their abilities.

In finance and investing, people who overestimate their knowledge and ability because of the Dunning-Kruger Effect may make unwise or overly risky investment decisions that can result in significant losses. This can happen, for example, when people feel confident in their ability to predict market trends or understand complex financial instruments, despite lacking the necessary expertise.

Key Takeaways

The Dunning-Kruger Effect is a psychological phenomenon in which people with low levels of skill or knowledge greatly overestimate their perceived skills of knowledge.
Those who score the worst on actual performance or knowledge are often the same ones who rate themselves most highly and confident in their (incorrect) claims.
At the same time, those individuals with actual skill or knowledge tend to underestimate their abilities in a phenomenon called imposter syndrome.
First described in a 1999 research paper, the Dunning-Kruger Effect has been replicated many times. It can affect many life aspects, including investing decisions.
Minimizing the Dunning-Kruger Effect can be achieved through education, training, accepting criticism and feedback, and taking in objective evaluations of knowledge or ability.

Why the Dunning-Kruger Effect Happens

The Dunning-Kruger Effect is thought to occur due to a combination of cognitive limitations and a lack of subjective self-awareness. Individuals with limited knowledge or expertise in a field are often unaware of their own limitations, which can result in an inflated sense of competence.

In other words, when someone doesn’t know what they don’t know, they are prone to overestimate their knowledge. It has been described colloquially as “dumb people who do not realize they are dumb.” At the same time, those with more expertise may come to underestimate their abilities as they become more aware of the complexities of their field.

The phenomenon was first described in a 1999 study titled “Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments,” by social psychologists David Dunning and Justin Kruger.

Another reason for the effect could be a lack of insight or metacognition, which is the capacity to reflect honestly and objectively on one’s own skills or performance. If someone consistently overestimates their abilities, they may also be more likely to reject feedback, which can play a role in continued underperformance.

In addition, the effect may occur as people use their own subjective criteria for what it means to be good at something, rather than objective, standardized measures.

The authors discovered that people with low levels of competence in a particular domain were more likely to overestimate their abilities, while those with higher levels of competence were more likely to underestimate their abilities, forming an inverted U-shaped plot. Dunning and Kruger assessed participants’ actual and perceived abilities in a disparate range of fields including humor, logical reasoning, and English grammar.

The Dunning-Kruger Effect is a type of cognitive bias. Many similar psychological biases affect financial investors, including representative bias, cognitive dissonance, confirmation bias, attachment bias, home-country bias, anchoring bias, and the endowment effect.

In the grammar study, college students completed a test on American Standard Written English, then self-evaluated their perceived grammar ability and expected test performance. Those who scored the lowest on the test tended to drastically overestimate both their perceived grammar ability and expected test score, while those who scored highest tended to underestimate their ability and test score.

Comparing self-assessments (subjective ability) with actual performance (objective ability) remains the primary way to detect and measure the Dunning-Kruger Effect. A 2008 study replicated the original findings, showing that people in the lower quarter in terms of actual performance expected to see results of 60% when they scored only 38.4%.

People in the middle half expected to score 72.6% but actually scored 61.7%. Meanwhile, those in the upper quarter expected to score 75.6% and actually scored higher, averaging 84.1%. Several other studies have also replicated these general findings across various contexts.

Dunning and Kruger’s findings show that as an individual’s actual competence increases, the disparity between self-assessment and actual performance decreases, eventually leading to a more accurate self-assessment.

Impact of the Dunning-Kruger Effect

The Dunning-Kruger Effect affects individuals across various fields, including business, finance, medicine, and politics. It can often lead to poor decision making, inefficiency, and other negative outcomes.

Dunning-Kruger Effect in the Workplace

The Dunning-Kruger Effect can manifest in the form of employees taking on tasks beyond their actual skill set or making decisions without fully understanding the ramifications or possible knock-on effects. Additionally, people who suffer from the effect may reject feedback or constructive criticism because they remain convinced of their own abilities and defend the choices that they have made. This can lead to a lack of growth and development, as well as difficulty working collaboratively with others.

One potential pitfall is that hiring managers may erroneously hire bad candidates who appear confident during the interview process but are actually victims of the Dunning-Kruger Effect. Similarly, promotions may be handed out to these types of employees for similar reasons.

Dunning-Kruger Effect in Business and Finance

The Dunning-Kruger Effect can significantly affect financial decisions and investment strategies. Inexperienced investors may overestimate their abilities to pick stocks, analyze companies, or predict market trends, leading to poor investment choices and potential financial losses. This also includes a failure to recognize risks that may be present but are not recognized.

People who overestimate their abilities may ignore expert advice, such as from a financial advisor, especially if that advice goes against their preconceived notions.

Dunning-Kruger Effect in Medicine

In medicine, this effect can lead to healthcare professionals overestimating their knowledge and making incorrect diagnoses or treatment recommendations. This can take the form of missing a critical diagnosis or failing to order the appropriate tests, leading to delayed treatment or even a misdiagnosis. This, of course, can have serious consequences for patient care and health outcomes.

How to Avoid the Dunning-Kruger Effect

To guard against the Dunning-Kruger Effect, it’s important to seek out diverse perspectives, recognize one’s own limitations, and be open to feedback and constructive criticism. Being both humble and realistic about one’s actual abilities and knowledge may be difficult, but it is critical for avoiding the pitfalls described above.

Engaging with colleagues, mentors, and subject matter experts can also help build a more accurate understanding of one’s knowledge and abilities and can help avoid costly mistakes. Don’t assume that you are superior or know more than those with expert training and credentials in a field. Indeed, education and training are the best way to gain the actual knowledge base needed to make expert claims.

Furthermore, healthcare organizations can establish clear guidelines and protocols for decision-making processes that individuals must follow regardless of what they think they know, and provide opportunities for professionals to collaborate and share their knowledge and expertise.

What is the ‘double curse’ of the Dunning-Kruger Effect?

The “double curse” of the Dunning-Kruger Effect arises when:

Low-skilled people greatly overestimate their own skills or knowledge
High-skilled people tend to underestimate their own skills or knowledge

Is the Dunning-Kruger Effect real?

Since the original study by Kruger and Dunning in 1999, several studies have replicated and supported the existence of their namesake effect across various domains. However, some scholars have questioned the statistical modeling used in the original study and criticized the overapplication of the theory to a range of situations where it might not be relevant. Despite these criticisms, the Dunning-Kruger Effect remains widely recognized as a genuine cognitive bias that can influence people’s perceptions of their own skills and knowledge.

What is the opposite of the Dunning-Kruger Effect?

While there is no exact opposite of the Dunning-Kruger Effect, imposter syndrome may be used to describe the fact that highly trained and skilled people may underestimate their own ability or worth. Imposter syndrome occurs when those who are competent and accomplished nevertheless feel like they are frauds or imposters who don’t deserve their success. This can lead to feelings of self-doubt, anxiety, and a fear of being exposed as a fraud.

Who is most susceptible to imposter syndrome?

Impostor syndrome can affect anyone, regardless of their profession, background, or level of achievement. However, it is commonly associated with high-achieving individuals, perfectionists, and/or those in competitive environments who may come to doubt their own abilities.

The Bottom Line

First identified in 1999 by a pair of psychologists, the Dunning-Kruger Effect describes a ubiquitous phenomenon among people in which those with low skill or knowledge tend to greatly overestimate their skills and knowledge. Conversely, those with great skill or knowledge tend to underestimate themselves instead.

The impact of the Dunning-Kruger Effect spans many domains and contexts, and in the world of business and investment can lead to poor hiring and promotion decisions, overconfidence, bad trading strategies, and excessive risk taking, among other detrimental effects. To minimize the Dunning-Kruger Effect, one can educate or train themselves to become an expert in a field, listen to knowledgeable advice and feedback, and be open to new ideas.