The Dunning Kruger Effect In Trading
How does the Dunning Kruger effect influence traders and how can you combat it?
Setting Trader Expectations
Most traders start off with a small amount of capital, money that they can afford to lose.
They may have seen a movie, heard a story, or personally know someone that made serious bank in
trading that they decide right then and there that they want a piece of the action too.
After all, the rules are simple, right!?
We buy low, and then we sell high. Simple, elegant, and definitely doable…
More often than not, this initial seed capital is small enough that they don’t feel emotional about it at all.
Make a first trade, execute a simple strategy to perfection, and then BOOM!
They quintuple their money in a matter of hours on some leveraged breakout trade.
Beginners Luck
They’re elated and overcome with excitement.
They now believe in their natural grasp on how trading works and have tangible proof that they can easily make profitable decisions.
This initial surge in confidence is the peak of the Dunning-Kruger Effect in trading.
Maybe they go around telling friends and family, calling Ferrari dealerships in anticipation of huge payouts and start loading up trading accounts with large sums of money they can’t really afford to lose.
After all, they’ll be rich in no time!
Not too far in the future though, and after a string of bad trades, they start to realise that trading is more intricate and nuanced than they initially thought.
They begin to hear about broader market trends, sentiment analysis, risk management, mass psychological factors, and a huge array of other variables that impact price movement.
The list goes on and on.
Along with this comes a massive dip in confidence, this is the “valley of despair”.
As more time and trades pass, our trader continues to learn and refine their skills, and they start
to gradually improve.
They become more educated and begin to trade with their emotions regulated.
They start feeling better again and the results are reflected in their account balance.
Our trader entered the arena with unrealistic expectations, but soon managed to dig themselves out
Setting Realistic Expectations
Setting realistic expectations in trading is crucial for a long and sustainable trading career.
Every single day, new traders dive into the markets with unrealistic expectations of quick and easy profits, getting rich quick, delusions of possessing an innate ability to accurately and consistently time and predict market movements, winning every single trade, negligible costs and fees, and neglecting proper education.
All too often, traders fall into this trap of unrealistic optimism, which only inevitably leads to disappointment, massive financial loss, and emotional stress.
For some, the valley of despair is insurmountable and they give up trading altogether.
Accepting the possibility of loss
Accepting the possibility of losses is crucial and part of the process.
Even the most experienced traders lose money. It’s part of the game.
In setting realistic expectations, acknowledging that losses can and will happen is the only way to manage and minimise them, rather than avoiding losses altogether.
If you want to avoid losses, avoid trading!
On the other end of the spectrum, avoid chasing unrealistic profits.
That self-proclaimed guru on social media does not do you any favours by anchoring your expected profits to levels that would take massive amounts of leverage to obtain in a short amount of time.
This is a very high-risk way to approach trading…
Creating a solid trading strategy
Creating a solid trading strategy is essential for setting realistic and achievable goals.
Your trading plan should include clear objectives, factoring in your risk tolerance and trading strategy into a well-defined set of rules.
This helps maintain discipline, emotional balance, and self-control.
You can start trading with a demo account as you start developing a new strategy from scratch, test it out with small amounts of real money as you continue to polish this new strategy, before eventually scaling up.
Nurturing a mindset of patience and continuous learning
Nurturing a mindset of patience and continuous learning is vital for long-term success.
Becoming a profitable trader takes time and effort, and to stay ahead, you must be constantly studying
and improving.
Attend webinars, read books, follow what is happening in the markets, seek insights from experienced traders in your community, and balance all this with the fact that your path in this journey is your own.
Jim Rohn said it best, “be a student, not a follower”.
Avoid falling into the trap of seeking instant profits and gratification that lead to impulsive decisions and actions.
Acknowledge that there is a learning curve, just as with any skill, and expect that you will need time to develop a deeper understanding of everything, and that you’ll need to revisit or even unlearn some things from time to time.
By maintaining a mindset of continuous learning, you will be able to monitor and adjust your strategies with respect to evolving market trends.
The market is an ever-evolving organism.
It must be approached with respect and humility, and to stay in it requires discipline, knowledge, and a realistic mindset.
By following the above suggestions, you give yourself a better shot at surviving the valleys and maintaining control through the peaks.
Remember, there may be lucky breaks, but there are no shortcuts to long-term success in this field.
Always keep your expectations grounded in reality and with that, you can navigate the markets with
confidence and clarity.
Good luck.