Dunning Kruger Effect in the Stock Market

This article on the ‘Dunning Kruger Effect’ is for all those who have entered the stock market after March 2020.

This article is not to discourage you, but to tell you that the market can make you extremely over-confident when it’s in a bull run.

The market will make you increase your investment at higher levels. It will also show you that more gains can be made in lower quality companies.

Those who have seen previous market cycles and know how to play it – will make a lot of money.

But for those with limited knowledge and experience, market success in the first few months or years – can do more harm than good.

To explain this, we will be using the ‘Dunning Kruger Effect‘ theory.

Dunning Kruger Effect - Stock Market
Dunning Kruger Effect – Stock Market

Let’s take an example to understand this.

Rohit enters the stock market in April 2020. The market has just crashed and top companies are trading 40-50% lower than the prices just two months ago in February 2020.

Rohit has lost his job due to Covid lockdown across the country.

He decides to try his luck in the stock market. He hopes to make investing or trading his full-time profession, through which he can earn money and also work from home.

A wish to be a full-time trader..

If this plan clicks, he would never have to worry about taking up a job.

Entering the stock market is easy. The investment amount is close to zero. He already has a mobile phone and the cost to open a demat account is less than ₹ 500.

Hardly any investment, but a chance to earn a lot of money – he thinks.

Rohit buys shares of a few top companies like HDFC Bank, TCS etc. in April 2020. Immediately after his purchase, the stock price begins to rise – after all, a new bull market seems to have begun.

He reads the forum on Moneycontrol and watches a few videos on YouTube. People are recommending smaller and lesser known companies – which are moving 5-10% almost every other day.

More names are being recommended with big targets on CNBC TV18. Analysts on business channels are sounding super bullish.

Making money is easy

He begins to think – why buy stocks like HDFC Bank or TCS which are moving up by 1-2%? Why not invest in a stock that’s being recommended on YouTube – which has just ‘broken out’ on the charts.

He buys a few lower quality companies – these stocks begin to give 30-40% returns in a short period of time.

Now, Rohit begins to get confident. Making money in the market isn’t very difficult. In fact, it’s easy – he thinks.

His stocks continue to move up. Rohit breaks his fixed deposits and other savings to buy more shares that are being recommended.

The stocks continue to zoom. Rohit is now earning 7-10% in a week, the kind of returns that a fixed deposit would give in 1-2 years.

Phase of Over Confidence and Greed

The bull market is roaring, Rohit’s stocks are touching new highs. His confidence is hitting new highs too.

Meanwhile, ‘Scam 1992’ has also released. Rohit begins to see himself as the next Harshad Mehta or Rakesh Jhunjhunwala.

Now, he thinks of selling his land or taking a loan to invest in the stock market. Interest on personal loan is 10-12% per year. In the market he is able to earn that much in a month.

As his greed for quick money increases, he brings more money to the market.

Rohit also learns about the derivative segment – Futures and Options. It’s possible to make money even faster here and the broker also provides additional margin.

The bull market is peaking, Rohit’s confidence and portfolio too are touching the sky. His portfolio is now full of companies, which most people haven’t even heard of.

The Fall..

What happens next is anyone’s guess. The fall is inevitable.

Unfortunately, this is the story of most individual investors in the stock market. They enter when the market has already run up a lot, buy mediocre companies and eventually end up losing all their money when the market crashes.

It has happened in 2008, in 2011 and after the mid-small cap rally in 2017. It will happen again. Just that no one knows when.

Most exit the market when they see their first bear market. The losses can truly be unbearable – especially if borrowed money has been invested in the market.

The confidence gets shattered. The bull market ego and arrogance would be severely punctured too.

Few survive to graduate..

Very few get past this stage. But those who survive – begin to learn that making money in the stock market is not easy.

It requires knowledge. It requires experience. It also requires a lot of patience.

The market will eventually end up teaching its new participants some lessons which they will never forget.

They’ll begin to realise that the only way to succeed in the stock market is to survive and be a life-long learner.

Whatsapp Follow

Leave a Comment