Mental Model: The Dunning–Kruger Effect

Charlie Munger Mental Models

The Dunning-Kruger Effect is when someone is so ignorant they lack the ability to realize just how ignorant they are, leading to a sort of delicious paradox.

Have you ever wondered why some people come to erroneous conclusions despite all the counter evidence, overestimate their abilities, and constantly make mistakes whereas other, more intelligent people often claim ignorance and throw things on the “too hard” pile?

I mean, the reality is that 49.99% of people must be below average at any given time at any given skill.  Yet, studies have shown that 90% of Swedish drivers believe they are above average, which is absurd.  Most people believe they are above average in physical appearance.  Most people believe they are above average when it comes to intelligence.  How do we explain this?

In psychology, there is a term for this particular type of cognitive bias and it makes for an excellent mental model and it is called the Dunning-Kruger effect.

The Dunning–Kruger effect is a cognitive bias in which an unskilled person makes poor decisions and reaches erroneous conclusions, but their incompetence denies them the metacognitive ability to realize their mistakes. The unskilled therefore suffer from illusory superiority, rating their own ability as above average, much higher than it actually is, while the highly skilled underrate their abilities, suffering from illusory inferiority. This leads to the perverse situation in which less competent people rate their own ability higher than more competent people. It also explains why actual competence may weaken self-confidence: because competent individuals falsely assume that others have an equivalent understanding. “Thus, the miscalibration of the incompetent stems from an error about the self, whereas the miscalibration of the highly competent stems from an error about others.”

In other words, the incompetent person is literally so incompetent that he doesn’t realize just how incompetent he is because he lacks the capacity to process that information.

Lack of Access to Performance Standards Data, or Ranking Systems, Explain Some of the Reason the Dunning-Kruger Effect Exists

Dunning and Kruger argued that the reason people feel this way is that many people don’t have access to performance standards data.  In other words, they don’t have a way to rank themselves against other drivers, or professors, or chefs.

Personally, I think this mental model could be exasperated by the “birds of a feather” nature of human relationships which causes people to be attracted socially, romantically, and professionally to those who are similar.  This could lead to an echo-chamber feedback that may explain things like a group of racists believing they are intellectually superior to other races despite the fact they would fail standardized tests and read at the equivalent of a third grade level.  Since they are only surrounded by others who are of comparable, limited ability, they don’t realize just how bad off they are relative to everyone else.  They literally lack the data and framework to come to this realization.

The Test for the Dunning-Kruger Effect

Kruger and Dunning believed that for any given skill, incompetent people will do four things: (more…)

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The Secret: Strike Deals Where Everyone Has Limited Downside and Harness the Super Power of Incentive

Some of you have been writing to me privately and asking about the early days when we started out and were trying to build our companies.  I thought it would be useful to share some of the things we did during that time that worked out well … and maybe I’ll even talk about those things that didn’t work out so favorably.  I hope you find it useful in your own endeavors.

When Aaron and I started our first business years and years ago, we needed to get thousands of products coded and online.  That would have taken tens of thousands of dollars in cash upfront with no promise of payout later.  That was a risk we weren’t willing to take, so instead, we came up with an idea that mirrored Charlie Munger’s super power of incentive mental model.

We went to a jewelry store and department store to purchase a range of high-end gifts, which we knew would hold their value.  This included a diamond and ruby tennis bracelet, bottles of Chanel perfume, a diamond watch, etc.

We then approached several close friends and family members and made them a deal: If they were able to code [x] products successfully within 90 days, and those products were done well enough that they reached [y] in sales, we would give them the items.  We made it a competition.  That way, they were working as entrepreneurs and knew that if it didn’t work out, they got nothing (no paycheck) but if it did, they won big

The Moral of the Story

In other words, they had nothing to risk but time and had a shot at getting some fantastic gifts.  We had virtually no financial risk because, if things went poorly, we could either return the items or sell them for what we paid.  (Always have a financial backup plan.)  If things went well (they did), we got to pay them out of profits and not use any of our own cash. Everyone wins.

In the end, everyone was happy.  Giving those things away was one of the best experiences I’ve ever had because it felt good to reward those who worked hard and delivered results.  I visited one of the workers a few hours ago and was reminded of this program when I saw the gifts.  She let me take a photo with my iPhone.  I had forgotten what some of the things looked like, but I have to say: Aaron and I have taste.

What I want you to learn from this is how you structure your business deals is almost as important as the investment itself.  This is why Benjamin Graham said not to ask if “XYZ” was a good investment, but rather, “on what terms and at what price“. Had I added these people to payroll and created a fixed expense, it could have taken that company down before it got off the ground.  We forced the firm to pay for its own expansion out of earnings.

A Secondary Financial Lesson: Know Your Target Audience

(This experience also taught me something that I truly didn’t understand because I was, to be honest, a clueless guy: Many (not all) women love jewelry.  I mean love it.  They were more excited to receive items like this than cash.  I’d want the money.  Or stock certificates.  I grossly underestimated the power of stereotypes and was promptly rebuked by almost every female in my life with a giant, “duh”.  Had I known this, I would have gotten far more pieces like the bracelet shown here, which caused two hardworking, very intelligent women to almost fight.  The moral: Know what motivates your target audience. For me, getting paid in stock is a huge incentive.  For other people, not so much.)

Diamond and Ruby Bracelet with Bottle of Coco Chanel Mademoiselle Perfume

Years and years ago, Aaron and I came up with an incentive system that caused a group of hard working women to help us launch one of our first businesses. This is the diamond and ruby bracelet that served as one of the prizes to those who delivered the highest performance.

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Mental Model: The Revolution of Satisfied Expectations

Charlie Munger Mental Models

By adding concepts to what Charlie Munger calls his "mental model" collection, one can take advantage of them (or guard against them) throughout life.

The Revolution of Satisfied Expectations: “Research conducted by Daniel Kahneman of Princeton University, and by others who have come to approximately the same conclusion, shows that most people judge their well-being not by measuring where they stand but rather based on whether they think their circumstances and income will improve in coming years.  For example, in the 1950s, when most American families lived in small houses, owned one car, and few if any family members attended college, people were in good spirits because they expected soon to earn and possess more.  Now most families live in larger houses, own at least two cars, and send most children to college – that is, they have what people of the 1950s dreamed of having.  But because most now have so much, it’s hard to expect that the coming years will bring even more.” Source: The Progress Paradox by Gregg Easterbrook

In other words, most people would be happier earning $50,000 a year but seeing their income increase each year, improving their furniture, getting a slightly nicer car, etc., than they would be if they made $500,000 a year but never saw any increase in income and they already had all of the things they want.  Again, it is completely and totally irrational.

This psychological tendency is one of the reasons the politicians of a nation are so successful at creating “back-door” tax revenue through inflation.  By printing more money than population growth alone demands each year, a nation’s central bank can effectively transfer some purchasing power from its citizens to the government.  Most people, whether talking about paychecks or social security benefits, would rather see an increase in the dollars they receive each year even if their purchasing power isn’t increasing.  They would be unhappy if the dollars they received decreased even if their purchasing power increased due to deflation.

Put another way, if you are the ruler of a nation, it is difficult to do what is best for the average citizen because most would be happier receiving a 3% wage increase even if inflation were running 4% (so they lost 1% purchasing power for each hour worked) than they would be getting a 25% pay cut but seeing their purchasing power increase by 30%.  Even though they would be far wealthier in the second situation, they would focus on the fact they were making $75 for every $100 they made before, even though their $75 now buys more. (more…)

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19th Century Peasant with Pigs

Gregg Easterbrook points out that Jesse Ausubel and Arnulf Grubler of Rockefeller University have proven that the typical hours spent working has been declining almost in a perfect line for 15 consecutive decades.

John Robinson of the University of Maryland and Geoffrey Godbey of Penn State University have done research showing that “Americans now have more free time than at any point in the nation’s history.”  They calculate that since 1960, the average American has gained 5 hours of free time per week even after adjusting for women entering the work force.

The pathetic part?  Their research shows most Americans use this free time to watch more television.

Compared to 1880, according to University of Chicago professor Robert Fogel, the average man has 40 hours of relaxation time per week (e.g., come home, take off your shoes, and sit on the couch or anything else that doesn’t require you to be working to support yourself).  The average woman has 30 more hours per week.  Much of this is due to the fact that we have laundry machines and dishwashers, power tools and electronics, which do the work for us.

All this bunk about the middle class shrinking?  It has literally never been so good in the history of the world.  We are sitting at the apex of a great civilization, folks.  So why are people so unhappy?  Other research has shown that happiness is the result of being richer than your neighbor.  It’s all about having more than your friends and family, not your absolute standard of living.  That is completely irrational.

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Mental Model: The Drunkard’s Search

Charlie Munger Mental Models

By adding concepts to what Charlie Munger calls his "mental model" collection, one can take advantage of them (or guard against them) throughout life.

The Drunkard’s Search: The tendency for people to search in the easiest places, rather than the ones that are the most likely to yield results.  The name comes from the idea of a drunkard seeking his car keys under a street lamp because the light is better instead of where he most likely lost them.

The drunkard’s search manifests itself constantly.

I think there is an argument to be made that the drunkard’s search concept can be expanded into behavioral economics.  For example, with the Great Recession of 2007-2009, one need look no further than the job market.  Most people are looking for work in the same communities where the factories have closed, the businesses are shuttered, and the wealthy fled long ago.  Why?  Because it is convenient, their children are enrolled in the local school district, and they own a house in the community.  Rather than looking for the best long-term solution to the problem and then moving across the country to areas where jobs are not scarce, they continue to hug the street lamp and insist there are “no jobs”.  They refuse, either through ignorance, stupidity, or denial, to realize there are no jobs next to this particular street lamp but there are plenty elsewhere. (more…)

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Mental Model: Satisficing

Charlie Munger Mental Models

By adding concepts to what Charlie Munger calls his "mental model" collection, one can take advantage of them (or guard against them) throughout life.

Satisficing: A psychological and economic phenomenon that results from consumers choosing a product that meets criteria at an adequate level, rather than expending a great deal more time to find a fully optimal solution.

Put another way, people are not looking for optimal solutions in their life.  They are looking for a combination of “just good enough” or “better than average” weighted by the total effort or cost expenditure necessary to acquire said solution.  People don’t want a better mouse trap, they want a mouse trap that works at the lowest price or effort.

This ties in with our mental models related to brands and marketing: For those who lack knowledge of a specific industry, such as fine watches or cars, brand names serve as a proxy to communicate information and serve as a type of insurance against making both errors of omission and commission.  If one wants a fine watch and knows nothing about the industry, it is a fair bet that a Rolex is going to be wildly known, respected, and live up to its reputation.  The newly wealthy, for example, would not be aware of brands such as A. Lange & Söhne.  Likewise, a doctor who wants a good piano isn’t going to be able to tell the difference in touch and action from a row of piano brands so purchasing a Steinway & Sons is going to suffice for his needs, ensuring that he will be respected and get quality for his piano choice.  Even though additional research could provide better savings or an even better brand of piano, satisficing results in him saying, “I want to be done with it and this works.” (more…)

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