Most people discuss money from a mathematical perspective instead of looking at it from the lens of behavioral finance.
It’s time to understand that humans aren’t perfectly rational creatures, especially not when it comes to money. They often make bad financial decisions not because they’re stupid, but because their brains systematically make errors when interpreting financial information.
These systematic errors in thinking are called cognitive biases.
In this episode, James talks about a cognitive bias called the Dunning-Kruger Effect, named after social psychologists David Dunning and Justin Kruger.
This bias describes how people with limited knowledge about an issue frequently overestimate their expertise and knowledge about it.
Dunning and Kruger found that the lower the level of expertise that people have about something, the more confident they are that they have the right answer to it.
The problem is that the people with the highest level of expertise are the least confident and least likely to speak up. They understand that the world is extremely complex and are, therefore, less likely to speak with certainty and authority.
Unfortunately, the Dunning-Kruger Effect is very common in the world of financial planning. People call their financial advisors and tell them that they read an article that told them to invest in a particular stock. After reading that one article, they’re certain that they should follow its advice and do so immediately.
Thankfully, people can reduce the Dunning-Kruger effect in a few ways.
- First, they shouldn’t jump to conclusions based on just one or two data points.
- Second, they should understand that market psychology often causes investors to make decisions based on emotion rather than expertise.
- Third, everyone should commit to being a lifelong learner and remember that no matter how much they think they know, there’s always something that they don’t know.