I was introduced to the Dunning-Kruger effect for the first time this week and was struck by the relevance it potentially has to the world of financial planning and investing.

In their 2009 article, “Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments”, Justin Kruger and David Dunning argue that incompetent individuals suffer a dual burden. Not only will unskilled people draw erroneous conclusions and make poor choices, but they will also lack the ability to realise it.

Kruger and Dunning conducted a series of tests for their hypothesis focused on humour (although this may be no laughing matter as we shall see), grammar and logical reasoning. They found that while on average we all tend to overestimate our ability, incompetent or unskilled people do so by a far wider margin. In all cases this presupposes individuals have the base level of understanding required to be able to make a judgement.

The authors cite a number of famous quotes to help summarise their thesis. For example, Charles Darwin said, “ignorance more frequently begets confidence than does knowledge”. Similarly, Thomas Jefferson wrote, “he who knows most, knows best how little he knows”.

A more parochial expression of this might be, “a little knowledge is a dangerous thing”.

There are two areas where I think the Dunning-Kruger effect has particular relevance in the world of financial planning and investing.

1.    Planning versus investing – I have had many conversations with prospective clients who have told me they “do it themselves”. When I ask them what “it” is many describe the process of deciding how to invest: which funds or stocks to pick for their ISA or SIPP. While this is clearly a crucial part of financial planning it is just that – a part. A failure to understand the holistic nature of the planning process, and to recognise that lack of understanding will lead to an incomplete approach being taken.

2.    The ‘star’ fund manager and portfolio performance – professional fund managers are not known for their lack of confidence, and this is all the more the case for so-called star fund managers. But to prove one’s worth as an investor takes consistency over many years and different economic conditions. A rising market, some lucky stock calls, and a coterie of increasingly sycophantic acolytes could easily lead a fund manager to over-estimate their own competence and not recognise this, leading eventually to some very painful results.

Looking on the bright side, Kruger and Dunning also found that individuals who received coaching significantly improved both their performance, and crucially their ability to judge their performance too. In other words, people can be taught competence and the ability to recognise their own competence or lack thereof. This may ultimately lead to improved outcomes as we all better understand when it makes sense to seek help.