Take a person who is confident in something they know nothing about. We all know them.
They believe in something with more conviction than other things they’re qualified to opine on. Ask a doctor how to avoid getting cancer and they might say, “There are common-sense practices, but it’s a complicated topic and we still need decades of research to really understand the issue. And even then there’s always just bad luck.” Then ask them how we can avoid the next recession and they may tell you in black-and-white terms what the Fed should do.
Let’s call this Level One confidence. You’re confident in something because you don’t know enough to realize how little confidence you should have. It’s driven by gut feelings and the belief that intelligence in one field justifies your expertise in another. It’s a mess, and one few people think they fall for because beliefs exempt from the nuance of real expertise are rubber stamped in your head as unequivocally true.
A step above this, let’s call it Level Two confidence, is when you’re confident about a topic tangential to your field of expertise. Say you’re an expert at building cars. Then someone asks you whether Tesla is overvalued. Since you know a lot about building cars you feel qualified to have an opinion. But car manufacturing is one of thousands of variables that goes into valuing car companies – and the most important variable is “whatever mood the market is in,” which isn’t the kind of thing engineers steeped in precision appreciate. It takes little effort to assume your skill in one field makes you an expert in a cousin field. The danger is that first cousins can have little in common.
Level Three confidence is an expert relying on something they don’t understand or ever think about. A baseball player might have no understanding of stadium economics. A carpenter likely doesn’t know the precise calculations of load-bearing physics. The careers of both rely on these things, but if you asked them about the topics they might reply, “Someone else takes care of it,” or “I just do it my way and it seems to work.” They are confident things will work yet are detached from controlling the outcome.
Level Four: You’ve read and understand the core principles of a topic. That gives you confidence that you know how it works. But you haven’t grasped that what matters in most fields are the combinations and permutations of the core principles, and what’s really important are the exceptions to the rules. Level Four confidence is what happens when ambitious college sophomores starts a hedge fund after reading The Intelligent Investor.
Level Five: You have real experience in a topic, valuable first-hand knowledge. But you mistakenly assume your experiences are normal and repeatable. The real-world experience gives you confidence that your views are accurate, but since what you’ve seen is more believable than what you’ve read, it might be a liability compared to those with no experience and a more open mind. This is especially true if your limited experience were in periods of extreme ups or downs.
Level Six: You’ve seen and experienced enough successes and failures in your field to throttle your confidence. No patterns emerge; everything looks like random chance. You’re borderline cynical. Many people get stuck here.
Level Seven: You have a realization: confidence isn’t black or white, all or nothing. It’s about odds and percentages. You have no idea how to calculate those odds – and when you try they lean heavily toward the outcome you want. But you’re finally thinking about confidence in a productive way.
Level Eight: You discover the concept of base rates, or the idea that the odds you place on an outcome should begin with the odds of all other previous attempts at that outcome, and then tweaked for characteristics unique to the thing you’re trying to predict. Say you’re about to run your first marathon. If 50% of people who have ever tried to run a marathon have failed to finish, you start with that probability and then adjust it for whatever kind of unique traits you have.
Level Nine: You’re now armed with just enough skills to backfire. You’re calculating odds based on base rates, but you’re wildly off in how unique you think your individual situation is. If half of people can’t finish a marathon, you say, “OK, but I’m in 3x better shape than the average marathon runner,” when in fact you’re nothing close. So now you have a useless prediction metric, but you’re highly confident in it – more confident than you’ve ever been – because you’re using math. An uncomfortable portion of professionals reside here.
Level Ten: If you’re lucky enough to break out of level nine – which often requires an environment tolerant of inaction and saying “I don’t know” – you realize that situations when you’re much different than average are rare. Nine times out of ten the only confidence you have is that your ability to predict something will be similar to everyone else’s attempt at predicting something.
Level Eleven: The rare occasion when you’re confident in an unusual outcome is when you start with a base rate and only adjust it based on data-driven studies that measure situations with the same unique characteristics that you have or are looking at. If an asset typically returns 6% a year, you’re only confident that it will return more if there is research showing that it tends to return more when something that’s currently happening – low valuations, higher growth, etc. – occurs. And the expected size of that outperformance is guided by what’s happened in the past, like its own base rate.
Level Twelve: Even when you have Level Eleven confidence you know that confidence is a game of odds, and almost all odds are less than 100. So even when you’re confident you prepare to be wrong, with room for error and humility. That gives you confidence that you can survive long enough to bet on the next thing you’re confident about.
Level Thirteen: You become so good at rationally deploying confidence that success comes your way. The more success, the more confidence you have in your skills. The more confidence you have in your skills, the more you think you can apply them to other fields, including fields you know nothing about.
Level Fourteen: See Level One. Right back to where we started.