The Dunning-Kruger Effect in Action

As a general guideline it is usually preferable to steer clear of jargon when dealing with clients. Regardless of the industry, minimizing jargon helps avoid confusion and miscommunication. In situations where avoiding jargon entirely is not possible, best efforts should be made to explain, in detail, exact meanings of terms that may be unfamiliar to a layperson.

This general rule applies to all businesses and industries and is particularly important in instances where the level of expertise between an insider and an outsider is substantial and good communication is critical to achieving the desired results. Two such industries come to mind immediately: Investing and Medicine.

If a doctor started throwing out large words and medical terms while dealing with a patient, chances are most of us would say they have a poor bedside manner. However, many of these same people would sit back in awe at an investment advisor doing the same thing and marvel at how smart they (seemingly) are rather than addressing their failure to effectively communicate with the audience.

In many cases where jargon is used in place of effective communication the root cause is a lack of proper understanding of the subject matter in the first place. In such cases jargon can be used as a crutch to hide a lack of knowledge or to confuse the other party into believing a level or expertise has been achieved that has not. This, unfortunately, is far too common in the investment industry, and it is quite costly to investors who count on so-called experts for advice or guidance.

Some of this is, no doubt, done in a premeditated and purposeful manner, with the intention of hiding inadequacies and failures. Most, however, is likely the result of denial. By no means is this phenomenon specific to the investment management industry, nor is it something that is newly discovered. Charles Darwin once quipped that “Ignorance more frequently begets confidence than does knowledge.” Anyone who has spent a significant amount of time around financial advisors can likely attest to this.

In a study published in 1999, psychologists David Dunning and Justin Kruger summarized this human cognitive bias and gave birth to what we now refer to as the Dunning-Kruger Effect. The Dunning-Kruger Effect is the tendency for people to overestimate their own abilities, in particular when those abilities are below average. A common example of this is how nearly everyone rates themselves an above average driver, when a basic understanding of math would confirm that this self-assessment cannot be correct in all instances.

The least competent people at any particular task tend to rate themselves the furthest from their actual abilities – that is, far too highly. This is a clear case of not knowing what they don’t know, or as Alexander Pope said “A little knowledge is a dangerous thing.” Jargon is often used to make one appear more intelligent to those who are not in-the-know. To those who are in-the-know, however, it is often quite clear that excessive use of jargon is a sign of this cognitive bias in action.

The Dunning-Kruger Effect was once again on full display recently when an industry insider, who shall remain nameless to preserve what remains of their reputation, presented a paper they wrote on the topic of emerging markets equities. Specifically, the issue being discussed was whether emerging markets are worth investing in, and if so, at what allocation. This is a valid topic and a worthwhile discussion. Good arguments abound on both sides, but so do the drawbacks. To answer these questions is a topic for another time, but for the time being it serves as the backdrop for an argument made in favor of a significant emerging markets allocation by the person in question.

There was only one argument made in favor of an allocation to emerging markets in this presentation. The argument can be summed up in two words: mean reversion. The presenter in effect suggested that because emerging markets have been doing poorly that they were due for a reversal in direction. The implication was that this would even happen within the current calendar year, a concerning assertion given the long-term approach this same person espoused earlier in the presentation.

Mean reversion, for those who are unfamiliar with the term is the idea that over time returns in a given asset class will tend to revert back to the mean. That is, while any given year’s return can be higher or lower, over time they will tend to steer toward the historical average.

To anyone listening to the original presentation with even the slightest inkling of understanding of investing, emerging markets, or for that matter anyone even paying close attention, the argument in favor of an emerging markets allocation due to mean reversion alone does not hold water. Fortunately the presenter seemed aware of this and attempted to hide the glaring holes in his argument by invoking 4 syllable words wherever possible.

Set aside for a moment that mean reversion is not a valid reason in and of itself, and also consider the fact that nowhere in the presentation (or the paper it was based on) was the actual mean return ever specified. Additionally, one could not calculate the mean themselves because the index used as a stand-in for the emerging markets asset class was never disclosed nor was a time period ever settled upon, though 20, 22 and 26-year time periods were mentioned throughout at various points. With all these issues, which only begin to scratch the surface, one can not consider this presentation as valuable in any way, nor can you consider this research in any manner.

We’ve not even begun to ask such important questions are whether the entire emerging markets category has changed over time rendering the mean, whatever it is, irrelevant, nor have we asked whether the time-period, somewhere between 20 and 26 years, is statistically significant to consider as the basis for any analysis.

Sadly, this type of jargon filled presentation focused on charts and numbers, designed to impress rather than inform, is not all that uncommon in the investment industry. Rather than learning anything from it we are all dumber for having listened. What’s perhaps even more concerning is that there was not so much as a peep from the audience questioning the methodology or conclusions from this so-called analysis, which maybe speaks volumes more about the industry than the original presentation itself, given that the audience was comprised of investment advisors.

Jargon is often necessary when discussing complex and specific matters, particularly in fields that seem to have languages all their own. This often becomes an opportunity for those who fancy themselves experts to impress others with their knowledge of terms, even though they may mis-apply those terms, or miss the point entirely. Sadly, this is an all too common occurrence in the investment management industry, both in presentations to other industry insiders, and likely more common still in discussions with clients.

As a client you are the one with the power. It is incumbent upon you to understand what is being explained and to have it make sense. If something doesn’t make sense it is often less about your lack of knowledge and more about the presenter’s inability to explain (or their lack of understanding).

When dealing with important issues like our health or our investments we need to have trusted service providers. Those that are truly good at their jobs will be able to explain complex topics and concepts in easy to understand language. Those that themselves do not fully grasp the concepts will resort to jargon and obfuscation in order to craft the appearance of expertise, an appearance that is little more than a thin façade.