The Dunning-Kruger effect is a cognitive bias in which people believe they are smarter than they really are. It’s not necessarily an outcome of poor self-awareness, but can also be a result of real-life experiences, especially in the financial markets.
The markets are up 60% in the last nine months, and 25% in the last six. It’s natural for most equity portfolios to have achieved returns in healthy double digits. However, if one attributes that performance to only their inherent and superior stock selection abilities, they may be in for a reality check later.
The way to judge ones superiority in investing is to measure the alpha (returns generated over and above what the index has), over multiple time frames and periods. In short, consistently higher alpha generation seems like a decent measure to go by.
For this year, the Dunning-Kruger can kick in out of (i) ignorance of the underlying market performance, or (ii) judgement basis a very short time period of just one year, and no experience in dealing with cycles.
Whichever the case, there are a few ways to overcome this and avoid consequences at a later point when the cycle turns:
View investments objectively and devoid of biases
Avoid forming conclusions based on short periods of time
Look at investing in a holistic manner, which goes beyond just your portfolio
Compare the right metrics
Keep an eye on the portfolio
Continuously monitor and asset rebalancing
Another effective way is to share ideas among a community of investors. Sharing ideas doesn’t equal to giving tips or imposing views; but should tilt towards challenging assumptions, and moving out of a comfort zone.
Stepping back from the portfolio, renewing perspective, and understanding boundaries of your thinking usually solves falling in the trap of biases; ensuring a higher probability of maintenance of superior returns in the future.
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