The first rule of the Dunning-Kruger club is, you don’t know that you’re a member of.
A Slovenian news portal ran a terrific article the other day that also featured an interview with professor David Dunning, who together with Justin Kruger discovered the behavioral bias known today as the Dunning-Kruger effect. The effect was described in their paper from 1999 titled “Unskilled and unaware of it: how difficulties in recognizing one’s own incompetence lead to inflated self-assessments”. In the paper they describe four studies in which they found participants scoring in the bottom quartile on tests of humour, grammar, and logic grossly overestimated their test performance and ability. They concluded people tend to hold overly favourable views of their abilities in many domains and suggest this overestimation occurs partly because people who are unskilled in these domains suffer a dual burden, not only do they reach incorrect conclusions and make bad choices, but their incompetence also robs them of the metacognitive ability to actually realize it. To put it in very plain terms, some people are so foolish, that they are incapable of even realising it.
What was also established in their paper, that “paradoxically, improving the skills of participants, and thus increasing their metacognitive competence, helped them recognize the limitations of their abilities” meaning people who are experts in one field have the capacity to better evaluate their skills and are not prone to exaggerating them in the same way as people, who have no clue [1]. If you are a professional in one field, you have for sure come across people like that, who have absolutely no clue about your profession, but are ever so “smart” about even the smallest details and always “know” what should be done, even though their bold ideas are not based on knowledge nor experience.
Many movie characters are an embodiment of the Dunning-Kruger effect, like Steve Carell as Michael Scott from The Office series (or Ricky Gervais as David Brent from the original The Office series). Also Baldrick from the Blackadder 1983 sitcom comes to mind (pictured below), with his “cunning plans” to which in one episode Lord Blackadder replies: “Am I jumping the gun, Baldrick, or are the words “I have a cunning plan” marching with ill-deserved confidence in the direction of this conversation?” to which Baldrick replies: “They certainly are.”
So where can the Dunning-Kruger effect have a negative influence on our retirement saving efforts? One area which comes to my mind first is its effect on how we invest our retirement savings. In many retirement plans members can choose freely in which funds or the combination of them they can invest and here the problems start. There are many studies analysing these self made portfolios that are most of the time badly diversified. Benartzi and Thaler [2] describe this nicely in their 2001 paper exposing how many members of defined contribution retirement plans naively diversify their portfolios following the “1/n strategy” in which they divide their contributions evenly across the funds offered by their pension plan. They found out that the proportion of assets invested in stocks depends strongly on the proportion of stock funds in the plan, and not on any expert knowledge or advice. This means if my pension plan offers me 3 funds, I just split my contributions between the 3 funds equally and if my plan would offer me 5 funds, I would without thinking split the contributions evenly between the 5 funds. The problem here is of course, that I am not paying any attention to the funds themselves, are they equity funds, bond funds, what are their fees, their allocation, … but I just skip all this and naively diversify my portfolio and think to myself I did a pretty good job. What if my plan only offered me 5 funds that invest in US stocks, or maybe all 5 funds invest in “emerging markets”, how well is my portfolio really diversified now? Not very well.
This is also one area that plan designers need to be very aware of and don`t design plans that would enable their members to easily fall victim to naive diversification, meaning don`t let your members make the hard choices without giving them proper advice. If this is not an option, I’m personally a huge fan of smart defaults and for most pension plan members a well balanced offer of default target date funds will do the job nicely, meaning members don`t need to make any investment decisions on their own and by default their contributions go to the appropriate target date fund with an investment mix designed by experts to best fit the individual members age. Those members who wish, can still make an active decision and switch funds, but we know from numerous studies, most stick with the default and in this case this is good for them (given target dates funds are designed appropriately and regularly monitored by plan sponsors for performance and fees). Similar to target date funds, which are very popular in US pension plans, in Europe some countries feature so-called life cycle funds, where the member is switched between funds when he ages, from more dynamic funds in the younger ages, to more conservative funds in the years closer to retirement.
What else can we do to battle with the Dunning-Kruger effect in retirement plans? Well taking professional advice from financial advisors is also one important step and this goes for the initial period, when we decide where we will invest our contributions and how much we will contribute, to the final stages of retirement saving, which is the decumulation phase, when we need to decide how we will convert our assets into an income stream. This phase is particularly difficult as one must factor in many variables, from estimates of our longevity, to future market performance. Different ways in which we can draw down our savings also have many small, but important details, so this is for sure one area where we do not want to let the Dunning-Kruger effect run loose, so seeking prudent advice can for sure help us navigate this.
Governments in some countries are also starting to help their citizens to navigate personal finances and a good example of this is the UK with their Money and Pensions Service (MaPS) which provides free and impartial debt advice, money guidance and pension guidance to members of the public. Making services like that free for the public can have huge advantages later down the line, as they help to steer people away from bad financial decisions and if this becomes more widespread and if we would have better financial education in our schools, just think of how many financial pitfalls we could avoid.
Also employers have a huge role to play not just in the design of their pension plans, making sure smart defaults are in place when it comes to contributions, investments and decumulation, but also making sure their employees receive proper financial advice regarding their choices in the entire life-cycle of their retirement plan and this is one area where plans can hugely improve their services.
So the next time when we want to get “smart” about some area in which we are no experts, don’t forget the first line of this article – The first rule of the Dunning-Kruger club is, you don’t know that you’re a member of.
References:
[1] Kruger, J. & Dunning, D. (2000). Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments. Journal of Personality and Social Psychology. https://www.researchgate.net/publication/12688660_Unskilled_and_Unaware_of_It_How_Difficulties_in_Recognizing_One’s_Own_Incompetence_Lead_to_Inflated_Self-Assessments
[2] Benartzi, S., & Thaler, R. H. (2001). Naive Diversification Strategies in Defined Contribution Saving Plans. The American Economic Review, 91(1), 79–98. http://www.jstor.org/stable/2677899
Irrational Retirement 