My new favorite random concept to drop into whatever conversation I happen to be having is the Dunning-Kruger effect. Ironically, I am currently somewhere near “Mount Stupid” in my understanding of this phenomenon.
So this post is, technically, an example of the Dunning-Kruger effect that uses an explanation of the Dunning-Kruger effect as its example.
They say "meta" is the new thing. So welcome to my metaverse, I guess.
How we usually think about the Dunning-Kruger effect is that, when initially encountering a new subject that they’re interested in, people tend to overestimate their competence the less they know.
A textbook example is that of a bank robber who was caught because he thought spraying lemon juice all over his face would make him invisible, and thus not recognizable after he washed it off. His reasoning was, of course, that if lemon juice was used in invisible ink then it would similarly obscure his facial features during the robbery.
Brilliant!
Traders in bitcoin and other crypto assets that joined our ranks in the past 6 months are now suffering hard from the Dunning-Kruger effect. It happens to everyone who begins their trading life in a bull market. Their early investing is so successful that they think they’re a genius. Obviously, the sick gains prove their strategy is correct! They forget to take profits. They leverage up. They sell long-term holds for assets further down the risk/reward ratio ladder. In the moment, these newb traders think they’re “diversifying” their portfolio, so they can capture even more alpha with their amazing strategy Big Brains. But in retrospect, they were just shooting themselves in the foot.
If this applies to you today, don’t worry! You just fell victim to the Dunning-Kruger effect. It happens to everyone. Full disclosure: It happened to me in 2017-18.
But there is a silver lining!
The Dunning-Kruger theory has an inverse corollary to its main takeaway that new market participants vastly overrate their competence.
It’s this:
As people become more competent, they have a tendency to underestimate their competence.
Next time around, you’ll do better even though you’ll probably be thinking the whole time about just how bad you’re doing!