Your Money: Beware the ‘illusion of knowledge’

Research shows informed people may think they may know more than they do

NYSE traders: Research suggests a strong link between overconfidence and overtrading. Photograph:  Eduardo Munoz Alvarez/Getty Images

NYSE traders: Research suggests a strong link between overconfidence and overtrading. Photograph: Eduardo Munoz Alvarez/Getty Images

 

Do you understand the basics about money, or are you liable to trip yourself up when it comes to everyday financial matters? Test your financial literacy by taking a quick quiz consisting of five relatively simple questions.

One: you have €100 in a savings account earning 2 per cent annually. After five years, will you have more than €102, exactly €102 or less than €102?

Two: your money is in a savings account earning 1 per cent interest. The annual rate of inflation is 2 per cent. After a year, will you be able to buy more with your money, less with your money, or the same?

Three: true or false: buying a single company’s stock usually provides a safer return than a stock fund.

Four: true or false: a 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest paid over the life of the loan will be less.

Five: if interest rates rise, what should happen to bond prices? Will they rise, fall, stay the same, or is there no relationship between the two?

Answers: one – More than €102; two – you will be able to buy less with your money; three – false; four – true; five – bond prices will fall.

If you answered all five questions correctly, give yourself a pat on the back – just 14 per cent of Americans managed to do so, according to a survey of more than 25,000 adults in 2012, with the average person scoring 2.88 out of five.

This confusion is not confined to the United States. A global survey found that in most countries the vast majority get at least one of the first three questions wrong. Only in two countries – Germany (53 per cent) and Switzerland (50 per cent) – did more than half of people answer the first three questions correctly.

If you managed to get a high score, you might like to rate your knowledge regarding some other personal finance terms. On a scale of one (never heard of it) to seven (very knowledgeable), rate your knowledge of the following terms: fixed-rate mortgage, home equity, tax bracket, annualised credit, stock options, inflation, pre- rated stocks, revolving credit, vesting, retirement, fixed-rate deduction, private equity fund, interest rate, and whole-life insurance.

Overclaiming

David Dunning

Self-perceived expertise causes people to think they know more than they really do.

In a related experiment, the researchers divided participants into three groups: one group was given an easy geography quiz, another group was assigned a difficult quiz, while no quiz was given to the third group. The easy quiz induced participants “to feel more knowledgeable”; afterwards they were more likely to claim knowledge of nonexistent places. The link between self-perceived knowledge and overclaiming persisted even when participants were warned that some terms were fictitious, the researchers found.

The results are revealing but not surprising; after all, that people are overconfident is “perhaps the most robust finding in the psychology of judgment”, as behavioural economist Richard Thaler once noted, with countless studies showing people habitually overestimate their knowledge, abilities and qualities.

When it comes to finance, failing to see or admit to one’s knowledge gaps “could lead to uninformed financial decisions with devastating consequences”, says Dunning.

Research suggests a strong link between overconfidence and overtrading, which inevitably impacts on investment results. Nor are “self-perceived experts” the only ones at risk; they may well “give bad counsel when they should give none”, adds Dunning, who cites research indicating people considering a financial decision are liable to consult friends who express confidence in their financial knowledge.

On a broader level, economists such as Nobel laureate Robert Shiller and Harvard’s Kenneth Rogoff have also noted that overconfidence is especially high at the peak of market bubbles, at the very time that people should be growing cautious.

Feeling of knowing

The problem, as Dunning notes, is that people “rely not only on a direct examination of their mental contents but also on a feeling of knowing”. This “feeling of knowing” is not necessarily impacted by obvious evidence to the contrary.

One study found that 23 per cent of bankrupts surveyed gave themselves the highest possible self-rating regarding financial ability, compared with 13 per cent of people who had not gone bankrupt. This inability or refusal to see the obvious is also evident in a 2014 study of UK prisoners, which found that the average prisoner rated himself to be more moral, kind, self-controlled, compassionate, generous, dependable, trustworthy and honest than the average non-prison member of the community.

The only trait where the average prisoner did not feel superior was in terms of being law-abiding; even here, they rated themselves as equal to the average community member.

In cases such as the above, it might be tempting to assume that the so-called Dunning-Kruger effect is at work. This refers to the well-validated finding that the most inflated self-assessments tend to be held by the poorest performers. Dunning refers to it as a “double curse” – the most incompetent people are the least likely to be able to identify their own incompetence, thus remaining ignorant of their own ignorance.

Danger of knowledge

However, overconfidence is not confined to the incompetent.

One survey, for example, found 42 per cent of engineers believed their work ranked in the top 5 per cent among their peers.

Another found that 94 per cent of college professors believed their work was above average, while overconfidence has also been well-documented among stock analysts, chief executive and investors of all hues.

Indeed, Dunning’s latest study found that claiming knowledge of nonexistent financial terms and concepts was not just found among egotistical people with an unrealistic self-image; genuine knowledge was also predictive of overclaiming.

This suggests there may be a negative side to financial education, namely that informed people may end up thinking they may know more than they really do.

Indeed, an unrelated study last year which examined the private investments of Swedish fund managers found that they “do not outperform, do not diversify their risks better, and do not exhibit lower behavioural biases” compared with ordinary investors. There are, the study concluded, “limits to the value added by financial expertise”.

Clearly, a little knowledge can be a very dangerous thing.

The irony is inescapable – self-perceived expertise may discourage people “from educating themselves in precisely those areas in which they consider themselves knowledgeable and that may be important to them”, says Dunning.

That’s why investors should remember that the “great menace” is “not ignorance, but the illusion of knowledge”.

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