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What can happen when you overrate your trading abilities?

How the Dunning-Kruger Effect Can Disrupt Your Trading

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Recently I wrote an article discussing cognitive biases. These are shortcuts we take in our thinking, usually on an unconscious level. Because cognitive biases ignore or distort the basic rules of logic, they tend to distort good judgment as well. This can cause problems if you are a binary options trader.

One cognitive bias which I talked about briefly is the Dunning-Kruger Effect.

Dunning-Kruger Effect: The tendency for skillful individuals to underestimate their ability and for unskilled individuals to overestimate their own.

The Dunning-Kruger Effect is worthy of a deeper discussion, because there are so many different ways it can make it cost you money.

Pride Goeth Before the Fall

The big hassle with the Dunning-Kruger Effect is that it is an emotionally charged bias. So figuring out whether it is affecting you or not can be difficult.

We have all met people who judged themselves through the Dunning-Kruger lens. To us, what was going on might have been obvious, but to them, it was seemingly impossible to see.

Think about that really smart student you met who got straight A’s in school and still thought she was not good enough. It was obvious to you and everyone else that she severely undervalued herself, but nothing you could say or do would convince her otherwise.

Depending on her situation, several different factors might have been playing into her Dunning-Kruger Effect. Maybe she was a perfectionist and actually quite proud, so nothing was good enough to satisfy her pride. It was never enough to simply be “good enough.” Or maybe she lacked pride altogether, and her poor self-esteem caused her to underestimate herself. Maybe her parents’ pride and absurd expectations that she always be number one distorted the mirror she saw herself in.

Conversely, we have all met people who severely overestimated their abilities. Consider that guy you met at the cocktail party who just would not shut up about his supposedly fascinating job, his perfect car, his perfect house, and his perfect wife. He was always quick to interject his opinion on everything under the sun, and was utterly convinced he was the life of the party.

Of course, he wasn’t, and nobody wanted to talk to him. The harder he tried to impress people, the more he drove them away. But recognizing that fact would have required he put his pride on the line, and that was never going to happen, because that would have threatened his carefully constructed identity.

What Can Happen When You Overrate Your Trading Abilities?

You now should have a pretty solid mental image of what the Dunning-Kruger Effect looks like. You also should be able to see why it can be difficult to identify it in yourself. It is never fun admitting to yourself that maybe the reality of your skills and abilities does not match the image you have of yourself.

As I stated earlier, pride goeth before the fall. Here are some of the pitfalls that can swallow your trading account when you believe yourself to be a better trader than you really are:

1. You might trade with more money than you can afford.
2. You may go live before you are ready.
3. You can go on tilt.

Let’s look at each in-depth.

1. You might trade with more money than you can afford.

A lot of binary options traders overestimate their ability starting out. As a result, they deposit more money in their accounts than they should.

I always recommend that you at least start out with enough money to keep your investment sizes under 5% of your total account. Beyond that, however, you may want to start out small.

In fact, it is commonly suggested that traders who are just starting out live for the first time (or the first time coming back from a major drawdown) fund their accounts with only 50% of what they ultimately intend to use. This is because traders are particularly prone to the Dunning-Kruger Effect when they are going live. After all, they feel confident enough to put money on the line—and sometimes they simply overestimate how confident they should be. They then end up losing lots of money.

The worst manifestation of this problem is jumping straight into live trading without demo trading first. No one is good enough to start trading real money without trading virtual money first. If you believe you are, you definitely are subject to Dunning-Kruger. Always start by funding your account with $0! Only after you are doing well in demo should you trade with real money.

You should always err on the side of caution when you are just starting out trading live (or trying to get back on your feet after a fall). If you want to trade with $1,000, consider starting with $500. If you want to start with $2,000, make it $1,000.

The most accurate reflection of your true abilities is your results. Once the results are there proving you can trade profitably, you can fund your account in full.

2. You go live before you are ready.

Coming back to what I just said about demo testing, it really is amazing what traders will do when they overestimate their abilities. Sometimes they demo test, but they do not really care what their results are. Other times, they not only skip demo testing, but skip backtesting too. They may even think it is okay to trade without a system, because they “know the market.”

Binary options make a lot of money from traders like these!

If the statistical proof is not there, you are not ready to trade, period. The evidence of your abilities is measurable and quantifiable. Your gut instincts are not—because gut instinct is not a trading ability, even if you think that it is.

Do not be one of the 95% of traders who fall victim to their own conceit! It may be “cool” to imagine that you are some kind of market genius who just instinctively knows whether price is going to go up or down, but nobody has that magical ability. Giving up that image of yourself may seem like a steep price if your pride is on the line, but you will have to decide if that price is worth it to you or not. Just remember that it is one you have to pay if you want to make some serious dough!

3. You go on tilt.

People who overrate their abilities often feel a need to “always be right.” The problem with this mindset is of course that no one can be right 100% of the time. If you are intent on believing that you can be, you will blind yourself to what is really going on in your account. This will, ironically, cause you to make more and more mistakes. The more obsessed you are with being right, the more wrong you are likely to be.

This is actually a pride-driven form of going on tilt. You lose a trade, so you shrug and move on. You lose another. This still is not outside the bounds of your expectations, so you keep trading.

Several losses later, you see that you in the middle of an unusually long losing streak. But you are too good for that! This couldn’t possibly be your fault. Clearly, something else is going on. You are right about what the market is doing—your timing is just a little bit off. It will catch up to your expectations. You just need to hang in there … and place another trade. Oh wait—there is no money left in your account. Especially when you are trading 60 second options.

A lot of traders blow their accounts like this, all in an effort to convince themselves of the impossible—that they can always be right. Somehow, losing all that money is less scary than admitting to the truth—that they are simply not as good as they think they are.

You may not think you can relate to that guy at the cocktail party who thinks he is the cat’s meow. But think for a moment about how that guy would trade. Are you trading like he would? You might have more in common with him than you care to admit. The sooner you see it, the sooner you can get back on track.

Beware of False Expertise

You should also be aware that you might occasionally get sucked into another trader’s Dunning-Kruger Effect. For example, you might have started talking to another trader on a forum about techniques. That person appears to know a lot more than you do and seems to be very confident with years of experience. He starts teaching you some stuff, and then seems to feel like he can give you advice at every turn. If you second-guess him, he makes you feel like an idiot.

With situations like this, oftentimes you are dealing with the guy at the cocktail party. Online, however, it can sometimes be harder to tell. It is easier for someone to lie about how extensive their experience is and how much money they make. Worst of all, people who falsely present themselves as bonafide experts often believe their own lies because of Dunning-Kruger.

Remember, taking too much advice from someone else suffering from the Dunning-Kruger Effect can harm your account! You may lose money following their advice, and you also may underrate your own expertise—which brings me to the next section.

What Can Happen When You Underrate Your Trading Abilities?

While Dunning-Kruger often leads traders to overrate their abilities, it sometimes leads them to underestimate their skills. This can also be very dangerous. For example:

1. You might second-guess your judgment even when it is spot-on.
2. You might continuously refuse to trade when you are fully capable of success.
3. You might break a trading system by trying to “fix” it when nothing was wrong with it in the first place.
4. You can further crash your self-esteem.
5. You might go on tilt.

Let’s again look at each of these in greater depth.

1. You might second-guess your judgment even when it is spot-on.

You may underestimate your abilities because you have low self-esteem, or you may do it simply because your standards are really high. Either way, this form of the Dunning-Kruger Effect can lead you to second-guess your judgments at every turn, even when those judgments initially made total sense. You may even find yourself mistrusting your own statistical results! At this point, you do not really have a clear gauge of what is going on, and you may start making stupid choices that cost you money you never had to lose.

2. You might refuse to trade when you are fully capable of success.

One of the worst things about underestimating your skills is that you may sit indefinitely on the sidelines. You may constantly be trying to attain the next level of improvement. “If I could just tack on another 3% to my win percentage …” “If I could only tack on one more winning trade per week …”

If you are profitable in testing and you have plenty of data backing that up, you can and probably should be trading live. You do not need to achieve perfection to be good enough to trade and make a solid living at it.

3. You might break a trading system by trying to “fix” it when nothing was wrong with it in the first place.

Here is a pitfall even veteran traders can fall into. You have a perfectly good working trading method, and you hit a hitch. There could be many reasons for this. Maybe you had a bad day and made an emotional trading decision. Maybe there has been an adjustment in market conditions. Maybe it is just a fluke.

Either way, because you are subject to the Dunning-Kruger Effect, your first move is to second-guess what you are doing. Because you believe your abilities are not up to snuff, you immediately blame your system. You think, “Obviously I do not know what I am doing. I need to go back to the drawing board and change things.”

At this point you launch into an obsessive quest for every flaw in your trading method. You search high and low for a new edge. If you take things to extremes, you might even scrap your entire system. You hunt for a replacement that will never break. This is known in trading as the “search for the Holy Grail.”

The real irony is that sometimes there is nothing wrong with your original trading method. Maybe it needs a minor adjustment—or maybe you just needed to wait for better trading conditions. So you end up creating a huge, expensive mess for yourself, all because you did not believe in your trading abilities.

4. You further crash your self-esteem.

Situations like the one above can lead to intense frustration. In some cases it may get so bad that you feel like quitting trading altogether.

The worst thing is that you are stockpiling a collection of imaginary failures. All of these supposed failures feed into your self-perpetuating belief that you are a failure. The hazard here is that over time, this can gradually erode at your self-esteem more and more. This in turn continues to feed the Dunning-Kruger Effect. After all, if you feel that bad about yourself, there must be a reason, right?

This is a vicious cycle, and it is one which can destroy a trading career.

5. You go on tilt.

When your self-esteem is low, you become prone to emotional behavior. It becomes easy to fly into desperation, rage or hopelessness at the drop of a hat. You lose a couple of trades and suddenly it seems like everything is falling apart. As a result, you may find yourself taking irresponsible gambles to try and win it all back. Or you might just give up and burn through the remainder of your bankroll as a way of throwing in the towel.

Conclusion: The Dunning-Kruger Effect Is a Stealthy Killer of Traders

Whether you overestimate or underestimate your abilities, the Dunning-Kruger Effect can have serious consequences. You dive into investments you cannot afford or refuse to take any risks at all. This can go on for any period of time: days, weeks, months, years, or even a lifetime. It impacts both new and veteran traders. Because your emotions can easily get tangled into the Dunning-Kruger Effect, they can blind you to the truth of what is really going on.

My best recommendation for avoiding this pitfall is to trust your statistics. If your statistics support your abilities, you have every reason to believe in them—even if you have self-esteem issues or you are a perfectionist. If your statistics do not support your abilities, you are not ready to trade, no matter how much you admire yourself.

If you do hit an unexpected snag when you are trading, do not make assumptions about the cause. Yes, it could point toward your abilities being at fault, but it could also have something to do with market context, emotions, or another factor. Troubleshoot the problem with care, and do not take any drastic steps unless you have a justifiable, data-driven reason to do so. Err on the side of caution, but do not stand in your own way when you do have the skills to profit.