You can lose money for strange reasons like knowledge and sense of control: 5 ways how Dunning-Kruger effect helps in managing your personal finance

The Dunning-Kruger effect is a cognitive bias where those who may not have high abilities or knowledge in an area tend to overestimate their competence and even the outcomes they get.

The problem noticed was that the lower the abilities/ knowledge, the higher the overestimation. This is partly due to the fact that they don’t know what they don’t know!

Conversely, those with higher abilities and knowledge tend to underestimate their performance or outcomes. This could be because these people know how much more they do not know and also have a greater understanding of the limitations that influence outcomes.


This is a very interesting behavioural phenomenon which complicates investing in many ways.

1-Mistaking outcome for skill: A rising tide lifts all boats, they say. Only when the tide recedes will one know who has been swimming naked, to quote the humourous and colourful language of the inimitable Warren Buffett.

When a certain asset class is in the bull phase, almost everyone who invests makes money. Many mistake that for investment acumen and their ability to correctly pick the right investments.

That is only till the music stops. Then it starts collapsing all around. First, the loss in profits shows up and then the losses show up.

2-Contrarian thinking: Sometimes the conviction is so total that one may feel that the entire market may be going wrong in either direction with respect to an asset or a stock. When that happens, one may start tilting at windmills when all the data and the market participants are pointing in some other direction.

This is another manifestation of this effect. We may feel invincible possibly due to some past wins. We may feel smug if we have read a lot in that area. Sometimes we may feel that we have some information or an invaluable insight which others may not have access to. Mostly all these are illusory, and the wisdom of the markets is mostly right, with very little that can be exploited. But that can be done by a professional who has the tools to get insights and act on it.

3-The illusion of knowing: There is a surfeit of information today on any subject. There is an opportunity for an investor to understand the terminology, investment thesis or even the specifics of how a product works. Understanding what is in a brochure is not the same as understanding investing or whether a product has a place in one’s portfolio.

For instance, knowing about asset allocation and diversification is not the same as knowing what will work in one’s case. That is because one lacks real world experience and expertise that the professional may have in that area. Also, there are convictions, conditioning and behavioural biases that an individual may labour under. The illusion of knowledge may offer false confidence and an illusion of competence, which is very dangerous in investing.

4-Our convictions can work against us: Sometimes knowing shows up as stories we tell ourselves which may fly in the face of what is happening in the economy and markets. A stock which has risen 70% may still attract more investment, as it could be explained away as a beneficiary of a structural/ management change in the company, a tweak in the strategy, marketing brilliance, unique proposition and moats which protect its position, etc. We may look around for information that would confirm our thesis. This is called confirmation bias.

Many times, these are explanations of what may be happening, may look like deep analysis, may appear like one has spotted a structural opportunity and may even start to look like foresight.

When a stock or an asset that we have built a strong thesis around starts dropping like a stone, we may stoutly defend our position and stand by our convictions. Then at a certain point, we may be convinced enough to come out but would not want to sell at a loss. We may want to wait for the stock/ asset to recover at least to the level we bought it. This psychological behaviour is called loss aversion.

5-The illusion of control: We want to believe we are in control. We keep looking at trends, economic data, central bank actions, analyst reports, trends, check price movements etc. Monitoring so much gives the illusion of control, though that is far from the truth.

Based on this, we may want to keep making changes too in the portfolio. Continuous activity looks responsible and again helps us feel we are in control. This is action bias at work where regular action looks like the responsible thing to do and waiting it out seems lazy and irresponsible.

The way out – Many investors want to do it themselves. Information is available to everyone today and there is little information asymmetry and arbitrage opportunities arising out of that.

The important thing today is how information will be used to take decisions. A mountain of information can lead to decision paralysis. As seen earlier, there are some very human problems - blind spots, behavioural biases, emotional drift, lack of contextual responses, knee-jerk reactions etc. All these can produce poor investment outcomes.

A good financial advisor overcomes most of the problems mentioned and would be able to offer contextual clarity about the right decision in one's case. A good advisor is even more useful in a world where there is an information overload and AI can give all the answers!

Suresh Sadagopan, the author, is MD & Principal Officer at Ladder7 Wealth Planners and the author of the book “If God Was Your Financial Planner”.