Research shows that 93% of Americans think they are better drivers than average. But not all of us can be above average, right? This is a classic example of the Dunning-Kruger effect.

In 1995, McArthur Wheeler walked into two Pittsburgh banks and robbed them in broad daylight, with no visible attempt at disguise. He was arrested later that night, less than an hour after surveillance photos of him were broadcast on the 11 o'clock news. When police showed him the surveillance tapes, Wheeler stared in disbelief. "But I wore the juice," he mumbled.

Apparently, Wheeler believed that rubbing lemon juice on his face would render him invisible to video cameras. After all, lemon juice is used as invisible ink, so why wouldn't it work on his face?

This bizarre case caught the attention of David Dunning, a Cornell psychology professor who, along with his graduate student Justin Kruger, saw in Wheeler's story something more than a tale of a spectacularly ill-informed criminal. They wondered: Could it be that Wheeler was too incompetent to recognize his own incompetence?

To test this hypothesis, Dunning and Kruger designed a series of experiments. In one study, they asked undergraduate students to rate their logical reasoning skills, grammatical skills, and humor. The students were then asked to take a test in each of these areas, and also to estimate how well they performed on the test compared to other students.

The results were striking. Students who scored in the bottom quartile on the tests grossly overestimated their own performance. Those in the 12th percentile of logical reasoning ability, for instance, estimated that they were in the 68th percentile. Meanwhile, students who scored highest often underestimated their performance.

Dunning and Kruger had discovered a cognitive bias in which people with limited knowledge or competence in a given intellectual or social domain greatly overestimate their own knowledge or competence in that domain relative to objective criteria or to the performance of their peers.

The only true wisdom is in knowing you know nothing — Socrates

In front of each are two buttons marked Healthy and Sick, along with two signal lights marked Right and Wrong. Every time the slide is projected, they register their guess as to whether the cell is healthy or sick by pressing the button so marked. After they guess, their signal light will flash Right or Wrong, informing them whether they have guessed correctly.

Here’s the hitch—only Smith gets true feedback. If he’s correct, his light flashes Right; if he’s wrong, it flashes Wrong. Because he’s getting true feedback, Smith soon starts getting around 80 percent correct, because it’s a matter of simple discrimination. Jones’s situation is entirely different. He doesn’t get true feedback based on guesses. Rather, the feedback he gets is based on Smith’s guesses! It doesn’t matter if he’s right or wrong about a particular slide; he’s told he’s right if Smith guessed right, or wrong if Smith guessed wrong. Of course, Jones doesn’t know this.

He’s been told that a true order exists that he can discover from the feedback. He’s left searching for order when there is no true order to be found. The moderator then asks Smith and Jones to discuss the rules they use for judging healthy and sick cells. Smith, who got true feedback, offers rules that are simple, concrete, and to the point. Jones, on the other hand, uses rules that are, out of necessity, subtle, complex, and highly adorned. After all, he had to base his opinions on contradictory guesses and hunches.

The amazing thing is that Smith doesn’t think Jones’s explanations are absurd, crazy, or unnecessarily complicated. He’s impressed by the “brilliance” of Jones’s method and feels inferior and vulnerable because of the pedestrian simplicity of his own rules. The more complicated and ornate Jones’s explanations, the more likely they are to convince Smith. Before the next test with new slides, the two are asked to guess who will do better this time around. All Joneses and most Smiths say that Jones will. In fact, Jones shows no improvement at all. Smith, on the other hand, does significantly worse than he did the first time because he’s now making guesses based on some of the complicated rules he learned from Jones.

Source: What Works on Wall Street by James O'Shaughnessy

If you found this interesting, check out the importance of standing by your beliefs.

Lane knew this, and despite his reservations, agreed to play along. Over the course of a few hours he wrote the single “Cherry Pie” which became Warrant’s most popular song ever, eventually reaching number 10 on the Billboard Hot 100. Years later Lane recalled the experience of writing “Cherry Pie” in an interview for VH1:

I hate that song. I had no intention of writing that song. The record was done. The record was called “Uncle Tom’s Cabin.” And Donny Ienner [Sony executive] called up and said, ‘I don’t hear the single.’So, that night I wrote “Cherry Pie.” Sent it to him. He looked at it over the weekend and all of a sudden the album’s called “Cherry Pie,” the record’s called “Cherry Pie,” I’m doing cherry pie eating contests … and my legacy is “Cherry Pie.” Everything about me is “Cherry Pie.” I’m “Cherry Pie” guy. I could shoot myself in the f***ing head for writing that song.

Lane would eventually drink himself to death in a hotel room.

The sad story of Jani Lane and “Cherry Pie” highlights the downsides of chasing commercial success at the expense of your beliefs and dignity. Unfortunately, with the rise of social media and algorithmically-controlled dopamine, this problem only seems to be getting worse.

Source: Reject the Algorithm, Nick Maggiulli

If you found this interesting, check out How Howard Hughes became the richest man in the world.

We don't have a monopoly. Anyone who wants to dig a well without a Hughes bit can always use a pick and shovel - Howard Hughes

At the beginning of the 20th century, the ever-increasing demand for oil was pushing companies and industries to find new oil fields and drill faster oil wells. Like everyone who drilled for oil, Howard Hughes Sr. also had trouble creating holes deep in the underground rock formations. The problem was that the existing drill bit at that time wore down too quickly and the process of replacing it was expensive and time-consuming.

Hughes began experimenting with different modifications to the existing tool bit and struck gold with an improved version in 1908. He patented it and started a company that unsurprisingly became extraordinarily successful - everyone who drilled an oil well wanted the best tool bit to optimize their cost and improve the chances of striking oil (running an oil rig was expensive at ~$250 per hour in the 1900s). In 1933, two engineers of the Hughes Tool Company invented the Tricone bit that drilled faster and straighter than any other drill bit in existence and immediately patented it. For the next 17 years the patent ran, and Hughes's market share approached 100% - Almost all the successful oil discoveries during this era were done using Hughes's tool and helped Howard Junior become the richest man in the world!

If you found this interesting, check out the power of brands.

Products are made in the factory, but brands are created in the mind. — Walter Landor

Michael Platt, director of the Wharton Neuroscience Initiative, conducted a fascinating brand-loyalty experiment where he and his team evaluated the brain activity of Apple and Samsung smartphone users. The test was to evaluate how users think and feel about the brands that they use.

Using an MRI machine, the team measured users’ brain activity to good, bad, or neutral news about Apple and Samsung. Apple customers showed an emotional empathy response to Apple that was identical to how somebody responds to hearing news about their own family. They were happy when news associated with Apple was positive and felt sad when it was negative.

On the other hand, Samsung users had no positive or negative responses to news about Samsung. Ironically, they showed a reverse empathy towards Apple — when Apple was associated with negative news sentiment, Samsung users felt happy. In their defense, Samsung users did not report feeling the results shown in their MRI. What they felt and the results measured using the MRI were completely different.

Apple has completely defined the market here. Samsung customers, it seems, from their brain data, are only buying Samsung because they hate Apple. — Michael Platt

Buffett intuitively understood this decades ago. In his 2007 letter to Berkshire Hathaway shareholders, he highlighted the power of brands in building an enduring business.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital… a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.

If you found this interesting, check out why it’s important to protect your downside.

Portfolio A grows 10% every year consistently but the catch is that once every ten years, it goes through a 50% drawdown. Portfolio B works exactly the same but only returns 5% and has a relatively lower drawdown of 20%. Finally, you have the option of parking your funds in a 10-year term deposit offering 2.5% APY.

The trick here is that most of us tend to allocate more importance to the returns generated by our investments than to their possible downsides. Simple math shows us that a loss of 10 percent necessitates an 11 percent gain to recover. Increase that loss to 25 percent and it takes a 33 percent gain to get back to break even. A 50 percent loss requires a 100 percent gain to get back to where the investment value started. This is why conserving your portfolio is more important than trying for maximum returns.

Coming back to our experiment, portfolio A starts off the strongest generating a yearly 10% return. Portfolio B also outperforms C with a 5% CAGR compared to the pitiful 2.5% return offered by the Term Deposit. But where it gets interesting is once you factor in the drawdown.

After 9 up years and 1 down year, portfolio A would have generated an 18% return (CAGR 1.24%), whereas portfolio B would have generated a 24% return (CAGR 2.18%). But, both of these portfolios would have been beaten by the term deposit offering a CAGR of 2.5% with zero volatility. (In this case, we have assumed the drawdown at year 5. The year in which the drawdown occurs does not matter for the overall return).

If you found this interesting, check out the case for strategic mediocrity.

Unsurprisingly, given the market conditions and high inflation of the 80s, investors were drawn to these high-yield junk bonds. Ben Trotsky was a bond manager working for Pacific Investment Management Company (PIMCO) during this time. Even though he was deeply skeptical about junk bonds, he devised a brilliant strategy for investing in junk bonds that he called “Strategic Mediocrity”

In his job as a bond manager, he had to beat the benchmark to get investors interested in his fund. What this means is that he was competing with hundreds of other money managers who were playing the same game. They all got ranked from best to worst – every day, every year, every five years, and so on.

What Ben decided was that he never wanted to be first in a particular year. Because anyone who ever got the No.1 rank almost certainly got it because they did something reckless, tried really hard, or took really big swings. They must have taken too much risk and it worked out in their favor that particular year – but, luck eventually runs out. When he did simulations of various long-term scenarios, everyone who showed up in the top slot eventually dropped out of the long-term rankings. But, if you stayed among the top 1/3rd consistently for a decade, you would end up in the top 10% of fund managers.

That’s the beauty of Strategic Mediocrity. You never risk it all trying to generate the highest possible return in a given year. You play it safe, do well but not too well & try to be in the top 30% of the fund managers every year. That means not buying the scariest junk bonds that could have the biggest payoffs but going for one of the barely junk ones. While other fund managers were caught off guard by the collapse of the junk bond market in the late 80s, Ben was able to weather the storm and emerge as one of the most successful fund managers in history. PIMCO now manages more than $1.7 trillion in assets!

If you found this interesting, check out the natural limit to growth.

When it was young, Hyperion could grow up to 10 feet per year under the right conditions. However, after more than 700 years, the tree now barely grows at 1.5 inches per year. The most common explanation for this decreasing growth rate is gravity. As trees grow taller, they must work harder to overcome gravity, pushing water and nutrients all the way to the top. Additionally, they face structural limitations in supporting their weight and increased wind exposure. Eventually, all trees reach an equilibrium.

Everything has a natural limit to growth. This concept is evident everywhere if you look around.

It is an elementary principle of aeronautics that the minimum speed needed to keep an aeroplane of a given shape in the air varies as the square root of its length. If its linear dimensions are increased four times, it must fly twice as fast.

Now, the power needed for the minimum speed increases more rapidly than the weight of the machine. So the larger aeroplane, which weighs sixty-four times as much as the smaller, needs one hundred and twenty-eight times its horsepower to keep up. — J. B. S. Haldane

Yet, most investors tend to forget this when they invest.

If you found this interesting, check out Salad Oil Scandal, American Express, & Warren Buffett

By then Tino had developed a cunning plan. He used his existing large pile of inventories of salad oil as collateral to get loans from Wall Street firms and buy Oil Futures so that he could drive up the price of his inventory. So, ships full of salad oil would dock in the port, inspectors from the banks would certify the quantity of the cargo, and then the banks would issue loans against these assets.

The inspectors just missed out on one simple thing - Oil floats on water.

Tino was fooling everyone by filling his tanks with water and then putting oil on top of it. If the banks had done even basic due diligence, they would have known that the total salad oil inventory reported by Tino was more than the holdings of the entire country. By the time Tino’s gig was up, they were supposed to have $150M in inventories but only had $6M¹. The futures market crashed and wiped out the entire value of the loans that de Angelis had taken.

A massive portion of the loans was funded by American Express. When Allied filed for Chapter 11 bankruptcy, AmEx was on the hook for the loans issued. AmEx nearly went under and the stock dropped more than 50% due to the scandal and that’s when Warren Buffett came in. Buffett took a 5% stake in the company for $20M and played an active part in repaying the creditors and building back the trust in the company. His bet paid off with AmEx stock jumping from 94 cents in ‘63 to $5 in ‘68, and Buffett exited his position.

Even though Buffett’s investment was an incredible success, what’s interesting is that AmEx has increased another 17x since Buffet sold his investments. The company has returned a CAGR of 13% compared to the 10% returned by the market. Buffett did end up buying back into the company in 1998 and currently owns ~18% of AmEx. Even someone like Buffett, who is famous for holding on to his investments and loathe to sell ended up selling too early.

If you found this interesting, check out the Japanese Asset Bubble

At its peak, it was rumored that Tokyo’s Imperial Palace was worth more than all the real estate in California — Yup, a patch of land in Tokyo, in theory, could buy you Hollywood, Silicon Valley, and all the beaches along the Pacific Coast. Makes perfect sense, right?

No one loves a never-ending party, especially central banks. By 1989, property prices were skyrocketing, and the equity market was in an explosive upswing. The Bank of Japan started feeling the heat and decided it was time to bring out the proverbial wet blanket with interest rate hikes. The Nikkei 225, which had reached a dizzying high of nearly 39,000 at the end of 1989, began to tumble.

What investors thought was a minor blip turned out to be a decade-long crash. The Japanese stock market dropped 60% between 1989 and 1992, and the real estate market also suffered a significant downturn — with prices falling by an incredible 70%! Japanese market still hasn’t recovered the heights it achieved during the 1989 rally, and the prolonged economic stagnation is referred to as Japan’s lost decades.

While the chart by itself looks horrifying, the real-life implications are even worse. Consider a Japanese worker who started working in 1980 and investing in the stock market. Assuming the worker invested $1,000 yearly over a 30-year career, by the time he/she retired in 2010, the $30,000 capital would have turned into $20,710 — a -31% return on invested capital over 30 years. In fact, from 2000 to 2010 (the last ten years of their career), there were only two years in which their total portfolio would have been green. Add to this the aging demographics; many older Japanese plan to work forever.

If you found this interesting, check out survivorship bias

The simplest solution would be to add more armor to the plane. But armor would make the planes heavier and less maneuverable making them even more vulnerable. Using too much or too little would both be an issue. Since it’s an optimization problem, they turned to data and analyzed the bullet holes and damage that the bombers suffered after each run and a clear picture started to emerge.

Now the solution was simple - Add armor to the areas that had the maximum chance of getting hit so that you minimize damage to the aircraft. Can you see the flaw in the plan?

Before the modifications were made, famous statistician Abraham Wald reviewed the data and found a critical flaw in the analysis - They were only looking at planes that came back. The areas with the minimum bullet holes were actually the most important since any hit there downed the plane. Wald’s recommendation was quickly put into effect and was so successful that it’s still being used today.