The Dunning-Kruger Effect: Can We Profit?
During my mini-vacation i got some interesting email from two intellectual friends, both related to the Dunning-Kruger effect. Neither friend seemed to be aware that this has been a basic theme of my blog for nearly five years, but both knew that I would be interested.
Even when on vacation, I always read Abnormal Returns. Citing last weekend's New York Times article on the subject, Tadas seized the theme to review analyst reaction to the impact of the oil spill on BP earnings.
This was a nice post, highlighting the dilemma and possible bias of analysts. Let us see what we can add.
Have you ever wondered why people with advanced degrees in climate science or biology don’t get online and debate global warming or evolution? Yet, people without a degree in psychology will write 1,200 words about a psychological bias. The less you know about a subject, the less you believe there is to know in total. Only once you have some experience do you start to recognize the breadth and depth you have yet to plunder.
I wonder about this question all of the time, and you should, too. Here are some simple propositions that I have advanced for years. I feel like it is a losing battle.
- Every source of information is good for something. The problem is what it is. I have given examples as simple as talking to cab drivers. (Obviously, I need one of our new resource pages on this).
- Most sources pontificate widely and loudly, reaching far beyond their area of expertise. Baseball fans should revisit my article on advice from "the Splendid Splinter" about waiting for the right pitch. Stay in what Ted called the happy zone.
- A valuable investor skill is identifying the real experts. Hardly anyone can do this. Evaluating expertise is difficult.
In my featured blogs, for example, I make personal decisions about whether the source is strong on a given topic.
A Few Examples
Every day you can read or watch a parade of pseudo-experts. Here are things they will say:
- Models are without value, "mark to myth", or error prone. This comes from people who have never built a model, did not take any class, and claim not to do forecasting. They do not understand that the process of building a formal model involves evaluating accuracy.
- Disparaging economic experts. This is a favorite of bloggers who talk pop economics. They are like the psychologist example cited above — they are confident that knowledge they do not have is irrelevant to the problem. How do they know?
- Giving lessons on public policy. The investment punditry enjoys pointing out how dumb those in Congress seem when on TV. They are blissfully unaware of how stupid they themselves seem to anyone who understands government. The punditry is used to calling the shots and making split-second decisions using a "rational" model. These pseudo-experts do not understand compromise, coalition-building, or political accountability. Their education started and ended with Mr. Smith Goes to Washington. When a market guy takes this approach, and lectures to government officials, he is really not taken seriously.
Most of the Internet audience is from a certain demographic and ideological audience that applauds sources and articles like my examples. They all cater to pre-conceived notions about knowledge, expertise, and decision-making. As a result, the articles are popular. This is good for TV ratings and page views.
Briefly put, most pundits and their readers are classic examples of the Dunning-Kruger effect. They are all blundering and they do not know what they do not know.
Anyone who is really serious about understanding the economy, public policy, and investing needs a special skill:
What can I really learn from this source?
I know that many readers are suspicious of information from popular sources like Jim Cramer, Larry Kudlow, Barney Frank or even Ben Bernanke. This is a mistake. Each is an expert on something important. I would be interested on reader comment on this. Please take the question seriously. What is the real "happy zone" for each source?
Tomorrow's Application: The Fed
There are a number of excellent sources on the Fed, policy options, and the likely choices. These sources share a number of traits including (but not limited to) the following:
- They have economic knowledge, supported by data. This should include some formal training, since that is how knowledge is acquired. If you do not understand this, you are a permanent resident of the Dunning-Kruger group.
- They have actual responsibility and decision-making experience. They have worked in policy-making roles, sometimes as key consultants to government agencies.
- They have no specific political agenda. They are invited to comment based upon expertise, not to "represent a viewpoint."
Here is another reader challenge: From the Fed commentators, see how many sources you can find who meet the criteria listed above.
To do so, you will have to fight your way through those who lack any real credentials, but nonetheless hold strong opinions about the stupidity of actual decision-makers.
The Fed needs to stimulate lending, increasing the velocity of money. Meanwhile, most of the criticism from the punditry points to the monetary base and emphasizes inflation fears.
I expect no policy change and little change in language. With no sign of inflation, the Fed will continue to emphasize the greater concern — deflation. This is more difficult to correct if a mistake is made. Briefly put, the Fed is going to support the economy until we have a clearer sign of self-sustaining growth.
This is the thing that many miss in their doom-and-gloom forecasts, just as they did in 2008. Policy makers will not sit idly by. No one predicted the wide range of Fed responses and loan facilities. Essentially, these pundits got it completely wrong when it came to predicting public policy outcomes.
When I invest for the long term, I find it helpful to have the government and the Fed on my side.
[full disclosure — I remain officially neutral on the Ticker Sense poll and slightly short in trading accounts]