Season Investments

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More Fool's Wisdom

Posted on March 8, 2016

On the heels of last week's post about Unintended Consequences and keeping with the tone of the election season, we thought it was an appropriate time to re-post one of our favorite Insights called A Fool's Wisdom. The original post was from January of last year, so we've updated some of the statistics as well as a new Super Tuesday edition of Lie Witness News from the Jimmy Kimbell Live! show. We hope that this week's re-post shows that confidence and knowledge are not necessary correlated (and often times uncorrelated), which is yet another important thing to keep in mind during an election season.

“The fool doth think he is wise, but the wise man knows himself to be a fool” – William Shakespeare, As You Like It

2015-01-27_Fool_Hat.jpgNo one likes to be called a fool and very few people consider themselves to be foolish, but the fact of the matter is that we all express some degree of overconfidence in our abilities or knowledge which lead to foolish decisions. One easy place to point the finger in our industry is market forecasters. At the start of 2014, the interest rate on the 10 year US Treasury Note was hovering just below 3% and oil was trading for around $100 per barrel. The conventional wisdom was that interest rates had nowhere to go but up and oil would continue to trade in the $100 per barrel range. Fast forward to today and the yield on the 10-year is hovering around 1.8% and oil is exchanging hands in the upper $30s per barrel. Needless to say, plenty of overconfident forecasters thought our current state of affairs was a near impossibility two years ago.

What is it about human nature that makes it so hard to simply admit “we don’t know” certain things? One of our favorite examples of this cognitive bias comes from Jimmy Kimmel’s bit called Lie Witness News in which Jimmy has his crew go out and ask people impossible questions with no correct answers. The embedded video was shot in Los Angeles last week on Super Tuesday when 13 states held their primary elections but not the state of California. People (including a Marlyn Monroe impersonator) were asked a variety of questions with no right answer ranging from the basic (Who did you vote for this morning?) to the totally obscure (Did you like that new hologram voting system?). In this no win situation, people chose to flat out lie about voting and chose to confidently validate the reporters ridiculous line of questioning rather than give the appearance that they weren't in tune with politics and admit that they didn't vote that moring.

This less than flattering aspect of our human nature is known as the Dunning-Kruger effect named after two social psychology professors from Cornell University who ran experiments to test “illusory superiority.” David Dunning and Justin Krueger decided to conduct the study after hearing the true story of a man named McArthur Wheeler who decided to rob two banks under the misguided belief that applying lemon juice to his face would make it invisible to security cameras.

Dunning and Kruger set out to study why human beings can possess extreme levels of confidence in things in which their level of understanding is clearly lacking. They conducted a series of experiments where students at Cornell were asked a variety of self-assessment questions related to logic, grammar, and humor. The students were then graded and shown the results of their tests to see how well they scored. What they found was that the students who scored the worst on the test were the most likely to grossly overestimate their relative knowledge. The participants who scored in the bottom quartile of all test scores estimated that they had scored above average in the 62nd percentile versus their peers. David Dunning summarized the results of his experiment by stating:

If you’re incompetent, you can’t know you’re incompetent…the skills you need to produce a right answer are exactly the skills you need to recognize what a right answer is.

The results of the Dunning-Krueger experiment are nicely summarized in the following chart.

2015-01-27_Dunning-Krueger_Curve.pngAccording to their research, the most confident people in this world are either experts or fools. Although Dunning and Krueger’s experiment was conducted fairly recently, this truism has been expressed by many great thinkers in the past. Consider the following quotes in addition to the opening quote by William Shakespeare:

Real knowledge is to know the extent of one’s ignorance – Confucius

I know that I know nothing – Socrates

[He] who knows nothing is closer to the truth than he whose mind is filled with falsehoods and errors. – Thomas Jefferson

The doorstep to the temple of wisdom is a knowledge of our own ignorance. – Benjamin Franklin

These sentiments could not be truer when it comes to our industry and investing in general. The truth of the matter is that no one knows the future and no one can completely understand something as complex as the global economy. Yet this fact doesn’t deter people from being overconfident in their “above average” ability to make good investment decisions. It is for this reason that we have chosen to emphasize a more humble approach to investing which spreads risk across multiple, uncorrelated asset classes (not just whatever is currently in vogue) and relies on trend following to guide our buy-and-sell decisions. It is because we inherently distrust our gut and our ability to pick next year’s winners and losers that we chose to rely heavily on our disciplined investment process. We are not afraid to admit we don’t know what the future holds or where the stock market is headed next. But this may not be a bad thing according to David Dunning who recently concluded, "Stumbling through all our cognitive clutter just to recognize a true 'I don’t know' may not constitute failure as much as it does an enviable success, a crucial signpost that shows us we are traveling in the right direction toward the truth."


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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