The Illusion of Knowledge | Personal Finance Series

A. What is The Illusion of Knowledge

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge. – Daniel J. Boorstin

The illusion of knowledge is a cognitive bias where a person mistakenly believes they understand a topic far better than they actually do.

It's often related to the illusion of explanatory depth, which is the feeling that we know how things work, but when we're asked to explain the details, we realize our understanding is superficial.

This bias is a significant obstacle to learning and can lead to poor decision-making because it prevents us from identifying what we don't know and seeking out accurate information.

B. The Dunning-Kruger effect

The knowledge illusion is also known as the Dunning-Kruger effect or the overconfidence effect.

The Dunning-Kruger effect is a cognitive bias in which people with low ability or knowledge in a specific area tend to greatly overestimate their own competence. Conversely, this effect also suggests that highly skilled people may underestimate their abilities, assuming that tasks they find easy are also easy for others.

This bias is a "dual burden" for those who experience it. Not only do they perform poorly, but their lack of skill and knowledge also prevents them from recognizing their own incompetence. This leads to a false sense of confidence and a resistance to learning or accepting feedback.

The effect was first described in a 1999 paper by psychologists David Dunning and Justin Kruger. In their studies, they found that participants who scored in the bottom quartile on tests of humor, logic, and grammar significantly overestimated their performance, sometimes rating themselves as above average. Meanwhile, the top performers, while more accurate in their self-assessments, often slightly underestimated their relative ability.

Why It Happens

The core of the Dunning-Kruger effect lies in metacognition, which is the ability to think about one's own thinking and knowledge. Those with a low level of competence lack the metacognitive skills to accurately judge their own performance. They don't have the foundational knowledge to understand what they don't know. As they gain more knowledge, they also gain the ability to recognize their own limitations, and their self-assessment becomes more realistic.

The Dunning-Kruger effect can be visually represented as a graph, often humorously referred to as "Mount Stupid." It shows a peak of overconfidence at the beginning of a learning journey, a dip in confidence as one realizes the complexity of the subject, and a gradual rise to a more realistic and grounded level of confidence as true expertise is developed.

The illusion of knowledge often arises from relying on passive learning methods.

What Are Passive Learning Methods?

Passive learning involves reviewing material without actively engaging with it. Examples include:

• Rereading notes multiple times.

• Copying text verbatim.

• Highlighting or underlining key phrases.

These techniques can create a false sense of familiarity. When you look at the material, you may feel like you know it because it looks recognizable. However, this is not the same as being able to recall the information from memory and apply it.

The Problem with Passive Learning

The issue is that passive methods don't test your ability to retrieve information. You are simply re-exposing yourself to the content. This can lead to a belief that you've mastered the subject, even though you haven't actually practiced recalling or using the information.

For example, imagine you're learning a mathematical formula. You read it repeatedly and can recognize it when you see it. However, if you're asked to solve a problem using that formula a week later without having practiced, you might find you can't remember the correct steps. The formula feels familiar, but you don't have the independent recall needed to use it effectively. This gap between what you think you know and what you can actually do can lead to poor performance on exams or in real-world applications.

Avoiding the Illusion of Knowledge

To truly master a topic, remember that familiarity is not the same as mastery. Simply recognizing information when you see it is different from being able to recall it on your own. The key to overcoming the illusion of knowledge is to use active learning strategies that force you to retrieve information from memory.

Use Active Learning Methods

Instead of passively re-reading or highlighting notes, try active learning methods. These techniques challenge you to recall information, helping you identify what you truly know versus what just seems familiar.

Some effective methods include:

• Flashcards: Write a question or a key term on one side of a card and the answer on the other. Actively trying to recall the answer before flipping the card is a powerful way to test your memory.

• Quizzes and Practice Tests: Use multiple-choice questions or fill-in-the-blank exercises. These force you to retrieve information rather than just recognizing it.

• Teaching others: Explaining a concept to someone else is one of the most effective ways to solidify your own understanding. If you can teach it, you likely know it well.

Test Your Knowledge Regularly

Regularly testing yourself over time is essential for moving information from short-term to long-term memory. This process, known as spaced repetition, helps to lengthen your "forgetting curve."

A great way to apply spaced repetition is with the Leitner system for flashcards. This method uses a tiered system to organize your cards:

1. Start with all your flashcards in Box 1.

2. When you answer a card correctly, move it to Box 2. If you get it wrong, it goes back to Box 1.

3. Continue this process, moving correctly answered cards to the next box (e.g., from Box 2 to Box 3, etc.).

4. You review the cards in Box 1 most frequently, while cards in later boxes are reviewed less often. This ensures you spend the most time on the topics you know least well, maximizing your study efficiency.

B. Examples of the Illusion of Knowledge

1. Following a "Guru": An investor watches a popular financial commentator on social media who makes a compelling case for a particular stock. The investor then buys the stock, feeling they have a solid understanding of the company's prospects. However, they haven't done their own research on the company's fundamentals, the competitive landscape, or the underlying risks.

2. Relying on a Single Metric: A person reads that a company's price-to-earnings (P/E) ratio is low and, believing they've found an undervalued stock, invests heavily. They overlook other crucial factors like the company's debt, cash flow, and industry growth, mistaking a single data point for comprehensive analysis.

3. Believing They Can Time the Market: An individual reads headlines about inflation or a potential recession and believes they can predict when the stock market will rise or fall. Based on this perceived knowledge, they sell all their investments to "wait for the dip," only to miss the market's eventual recovery and end up buying back in at a higher price.

C. Impact on Personal Finance and Investing

The illusion of knowledge can be particularly dangerous in personal finance and investing because it leads to overconfidence, which in turn can lead to poor financial decisions.

People might rely on general, superficial information from social media or news headlines and believe they have the expertise of a professional.

This can cause them to take on excessive risk, fail to diversify their portfolios properly, and engage in frequent, ill-timed trades.

D. Examples of the Illusion of Knowledge in Finance

Here are three examples of how this bias can impact personal finance and investing:

1. Overconfident stock picking: An investor reads a few articles about a hot new technology company and feels they "get" the business. They may then allocate a significant portion of their portfolio to this single stock, believing they've found a surefire winner. However, their understanding is based on a few general headlines and not on a deep analysis of the company's financial statements, competitive landscape, or long-term risks. When the stock price drops, they might be surprised and unable to articulate why, revealing their lack of true knowledge.

2. Market timing: An investor might closely follow financial news and believe they can predict short-term market movements. They see a news story about an upcoming economic report or a central bank's policy decision and convince themselves they know what will happen. This leads them to engage in frequent buying and selling, or "market timing," which is notoriously difficult to do successfully and often results in higher transaction costs and missed opportunities compared to a long-term, buy-and-hold strategy.

3. Ignoring diversification: The illusion of knowledge can make an investor feel they don't need to diversify. They might believe their stock-picking skills are so good that they can simply pick a handful of winning stocks and outperform a diversified index fund. This leads them to hold a concentrated portfolio, which is exposed to a high degree of specific risk. If one of their "sure thing" stocks fails, their entire portfolio can suffer significant losses.

4. Frequent trading: Overconfident investors may trade frequently based on news or short-term trends, incurring high transaction costs and potentially missing out on long-term gains.

The illusion of knowledge is a real danger when managing our money.

E. What is the "Illusion of Skill Acquisition"?

The illusion of skill acquisition is a specific type of the illusion of knowledge. It's the cognitive bias where a person overestimates their ability to perform a skill after merely watching others perform it, without any hands-on practice.

This bias occurs because watching someone perform a task gives you a visual roadmap of the steps involved, creating a feeling of understanding.

However, it fails to provide the critical feedback you would get from actually doing the task, such as the physical sensations, timing, and unexpected challenges.

In the world of personal finance, this can be seen when someone watches hours of YouTube tutorials on day trading and then believes they are ready to become a full-time trader, only to discover their lack of practical experience leads to significant losses.

Reference Link:

https://www.oaktreecapital.com/insights/memo/the-illusion-of-knowledge

https://www.bbc.com/worklife/article/20220812-the-illusion-of-knowledge-that-makes-people-overconfident

https://www.my-oxford.com/en/blog/the-illusion-of-knowledge-why-do-you-think-you-know-a-lesson-when-you-dont-2/

https://www.youtube.com/watch?v=y50i1bI2uN4

https://medium.com/the-productivity-playbook/illusion-of-knowledge-91aec59901cb

Happy Investing! 😉