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Mind the gap between what you know and what you think you know

Investors can never be so sure of themselves they could not benefit from a set and repeatable process and a few other people around to sense-check their conclusions

02/07/2018

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” This quote tends to be attributed to Mark Twain – and certainly it sounds like the sort of observation he might have made. Ironically enough, however, given it relates to knowledge and certainty, there is no real evidence – no matter what the internet might assure us – that Twain actually said or wrote any such thing.

The ‘Twain’ line sprang to mind as we read an interesting paper from 2016, entitled Precautionary savings, retirement planning and misperceptions of financial literacy. It was written by Anders Anderson, Forest Baker and David Robinson, who started off by asking their test subjects five basic financial literacy questions – on compounding, inflation, diversification, mortgages and bond pricing.

So far, so standard – indeed, you may have come across the very same multiple-choice National Financial Capability Study quiz before while, here on The Value Perspective, we invited you try your hand at something similar in Love and money. What is interesting about this paper is the identity of the test subjects and the fact that, once they had answered the questions, they were asked how they thought they had done.

All the guinea-pigs were contacted through LinkedIn, which led to a much higher average level of financial literacy being on display compared with previous studies of this kind. Even so, only a quarter of those tested managed to get all five questions correct and even among the chief executive officers, chief operating officers and chief financial officers tested, only two-thirds got every one of the questions right.

Oh well – as we have recently pointed out in both Five famous chief executive gaffes and Company bosses are human too, everybody makes mistakes. What is more curious, however, is the research paper’s suggestion that, while everybody knows people in general make mistakes, they are apparently less aware of their own fallibilities. 

Knowledge gap

When the test subjects were asked how they thought they had done, the ones who made no mistakes tended to be pretty sure of themselves. They largely thought they had got five out of five and indeed they had – they knew what they knew. As the following chart illustrates, however, the fewer questions people got right, the more how they thought they had done diverged from how they had actually done.

 

Source: NBER Working Paper No.21356, National Bureau of Economic Research, July 2016

From the five-out-of-five set slightly underestimating how well they had done, people’s perceptions of their financial literacy grow more out of kilter with reality – so that, by the time we get to the zero-correct camp, on average they were under the impression they would score much closer to two out of five. To put it another way, the triangle bounded by the two lines and the Y axis above is an increasingly worrying ‘knowledge gap’.

Clearly, if that knowledge gap is constant, there will be a lot of people making poor financial decisions and failing to put aside enough for their retirement or even a rainy day. More specifically to value investment, meanwhile, the study once again underlines how investors can never be so sure of themselves they could not benefit from a set and repeatable process and a few other people around to sense-check their conclusions.

As it happens, the ‘Twain’ line features at the start of the film of Michael Lewis’s book The Big Short. The book itself, however, kicks off a genuine Leo Tolstoy line: “The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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