The importance of circle of competence

Table of Contents

Where did it come from?

In his 1996 letter to Berkshire Hathaway, Buffett further expanded:

What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence.

The circle of competence that Buffett has repeatedly emphasized in Haaretz, March 23, 2011 is “The important thing is to know what you know and know what you don’t know.” — The key point is that the boundary is very important. Most things are incomprehensible.

Many investing masters endorsed

Since Buffett and Munger proposed that investors should pay attention to and limit their investment scope within their own ability circle (in fact, Peter Lin District has also mentioned similar views, interested readers can look at my blog for his book I wrote a brief introduction, “One up on Wall Street“), after the idea that the probability of success can be improved. I found that most people generally agree with each other in concept; but how to discover their own circle of competence, or the actual benefits of their investment, are quite divided.

Lynch’s view

As Lynch said, “You have to understand the business. And understand the fundamentals.” Know the basics of how an industry operates and where you have insight.

Lynch also said, “Never invest in any idea you can’t illustrate with a crayon.” Find simple businesses you grasp.

Lynch admitted, “I don’t invest in technology. Too much risk, too little brains.” So, stay disciplined in avoiding the areas you don’t comprehend, no matter how promising they appear in the moment.

Buffett’s view

Buffett’s 1999 shareholder letter cites an example to illustrate: “Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which Charlie and I have no special capital-allocation expertise. For instance, we bring nothing to the table when it comes to evaluating patents, manufacturing processes or geological prospects. So we simply don’t get into judgments in those fields.

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.

If others claim predictive skill in those industries — and seem to have their claims validated by the behavior of the stock market — we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it’s almost certain there will be opportunities from time to time for Berkshire to do well within the circle we’ve staked out.”

Munger’s View

Set limits on yourself

“The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much.” Munger once said.

Everyone’s competence circle will be unique based on their background and experiences. Munger noted that “competency is a relative concept.” An engineer’s circle will differ from a lawyer’s. But we all have areas we grasp better than high finance professionals, which gives the average investor an edge over the professionals.

Avoiding areas outside your circle

Equally important as investing in your circle of competence is avoiding what lies outside of it. Munger warned, “If you are playing games where other people have the aptitudes, and you don’t, you’re going to lose.”

Draw on your personal interests and experiences. Munger explained, “You have to figure out where you’ve got an edge.” Anchoring investments to your competence circle allows you to capitalize on information asymmetries.

Metaphor

Munger told Berkshire shareholders in 2017: “I have a friend who says the first rule of fishing is to fish where the fish are. The second rule of fishing is to never forget the first rule. We’ve gotten good at fishing where the fish are.”

“With regard to investment, we have three options: yes, no, too difficult. Unless we are particularly optimistic about a project, we classify it as a “too difficult” option. All you need to do is look for a special area of competence and focus on it.”

Munger distinguished investments into: those that can be invested, those that cannot be invested, and those that are too difficult to understand. He often says that he and Buffett will decisively classify potential investment projects as “too difficult.” If they can’t understand it, they give up.

Daily Journal meeting

In 2020 Daily Journal meeting, he said: “I think about things where I have an advantage over other people. I don’t play in a game where the other people are wise and I’m stupid. I look for a place where I’m wise and they’re stupid. You have to know the edge of your own competency. I’m very good at knowing when I can’t handle something.”

“Well it’s a hugely important thing, knowing the edge. It’s hardly a competence if you don’t know the edge of it. You know, if you have a misapprehension regarding your own competency that means you lack competence, you’re going to make terrible mistakes. I think you’ve got to constantly measure what you achieve against other people of achievement, and you have to keep being determinedly rational, and avoiding a lot of self-delusion,” Munger said at the 2019 Daily Journal meeting.

Reasons for opposing circle of competence

As mentioned earlier, most people basically agree with this concept. The main reasons of the opponents are the less rational and unbelievers (this situation is not included in the discussion, because it is difficult to reason or be persuaded), the main reason of the opponents will greatly limit the scope of investment and optional targets. Which is to reduce the possibility of making money. But this view is specious:

Investing should concentrate on limited target: Buffett once put forward the analogy that there are only 20 investment opportunities in a lifetime. In this way, investors will be more cautious in choosing stocks, and the probability of success will increase. For details, please refer to my previous blog article “Why concentrated investment?“
I personally have also pointed out many times that a person can make investors very wealthy by only looking at two or three stocks during his entire investment career. For details, please refer to my previous blog article “Good Companies are rare, two or three will make you rich. Take Texas Instruments as an example“
As I listed in section 5-5 of my book “The Rules of Super Growth Stocks Investing”, most of the more successful investors in history have advocated centralized investment, especially for retail investors.

Advantages of investing in the circle of competence

The following points are common, but they are very important; because to invest success, the decision is usually based on these small details:

The basis for investment judgment when necessary. Because you will have better knowledge than average people, you will be more accurate, and your judgments will be more correct.
Increasing your confidence in holding stocks, will not follow the crowd, nor will you sell stocks when the market crash, leading to regrets when the market recovers.

What if I don’t have any circle of competence?

This is impossible! Everyone must to have circle of competence. The competence circle does not mean that you must be a super expert in a certain field or have won a Nobel Prize, as long as you have a deeper understanding than most people (this is not an absolute, but a relative term). There are not so many Nobel Prize winners, and Nobel Prize winners are not necessarily experts in investing in their fields.

It is very good to have a more professional background or a superior or a top expert in a certain field; but this does not guarantee that the investment will be successful, and there is no inevitable relationship between the two. This is a big myth for ordinary people, and it is also described in another article on my blog “Why successful manager usually not a good investors?”

But if I am just an ordinary person, without a good education, no good job, my job is not a professional job; I am just a 9 to 5 office worker, and I’m a woman want to chase dramas on holidays, or a men to play video games all day long (above just for the sake of example, without any gender discrimination or other connotations), or find friends for dinner and coffee. How can this be incompetent?

You must know what movie or series everyone is watching nowadays than most people (at least much better than me). Which game is the most fun and most people are playing, you must know that. That restaurant or cafe is crowded every day, and you can’t make a reservation every time you want to make a reservation.

If I don’t play video games, I don’t chase dramas, and I don’t like to go out for dinner, coffee or chat. Then you always go to the supermarket to buy things, right? What do people buy on the trolleys in the supermarket? The prices of those goods increase every three or five times, but the items are all empty? I don’t go to the supermarket, but my family go. Do you always have a cell phone?

You always know the difference between Apple’s phones and Android phones? It’s impossible for modern people not to surf the Internet, right? Have you always used a computer or mobile phone to on Internet? Even the Taiwan government must go online to sign up for vaccines and consumer coupons. Few people will give up NT$ five thousand consumer coupons that have fallen from the sky, right?

How to discover your circle of competence

I personally think that there are several very ordinary ways to discover your investment circle of competence:

Find out the records of your past investments (readers can refer to my blog article “What information should investors take notes? Why?“) and review them carefully. Figure out the big money earned from which stock? What do these stocks have in common? think about it carefully, there must be a certain relationship between them ─ this is your circle of competence.
Your job, as long as it is a job, is professional.
Outside of work, the activities that you spend the most time on are also your special interests. As long as you are interested, you can accumulate considerable experience and knowledge for many years.
Your educational background.
What kind of non-fiction book do you like the most?

In short, everyone must have a circle of competence, it is impossible not to have it.

Disclaimer

The content of this site is the author’s personal opinions and is for reference only. I am not responsible for the correctness, opinions, and immediacy of the content and information of the article. Readers must make their own judgments.
I shall not be liable for any damages or other legal liabilities for the direct or indirect losses caused by the readers’ direct or indirect reliance on and reference to the information on this site, or all the responsibilities arising therefrom, as a result of any investment behavior.