Understanding one’s circle of competence helps you avoid problems, identify strengths, find opportunities for improvement in any field, and help you learn from others.
Warren Buffett is often quoted when any discussion of a circle of competence is begun. He has used this description to help investors focus on the areas they knew best. He first shared his thoughts on this concept in his 1996 Letter to Shareholders:
“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 size of that circle is not very important; knowing its boundaries, however, is vital.”
A circle of competence is often related to investing. Still, it encompasses much more than that, often a circle of competence relates to our jobs, hobbies, learning at school, and many more.
In today’s post, we will discuss:
- What is a Circle of Competence
- Warren Buffett and the Circle of Competence
- How to Define Your Circle of Competence
Ok, let’s dive in and explore more about the circle of competence.
What is a Circle of Competence?
“You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence. The size of that circle is not very important; however, knowing its boundaries is vital.”
An explanation of the circle of competence from Farnam Street:
“Circle of Competence is simple: Each of us, through experience or study, has built up useful knowledge on certain areas of the world. Some areas are understood by most of us, while some areas require a lot more specialty to evaluate.”
Most of us are familiar with restaurants and how they work. We buy a space, rent it out or buy the land and build our building. We create a menu, hire staff, serve the food, take payments, and pay our bills. What is left over is either for the owners to keep or reinvest back into the restaurant.
The restaurant business is fairly simple, and most of us can understand how this works, but how many can say they understand how Microsoft or Google works, or even Wells Fargo?
Most of us are unfamiliar with those types of businesses, and yet most investors you find on Robinhood are investing in tech, even though that may be out of their circle of competence.
Going outside of our circle can lead to some pretty disastrous consequences.
As Buffett has illustrated time and time again, we don’t need to necessarily understand the goings-on with Facebook to invest our hard-earned capital.
More importantly, we must be honest with ourselves and analyze what is in our circle of competence and try to stay within those bounds.
Put this way, think of the great swimmer Michael Phelps. If you try to make him the next Michael Jordan, probably not going to work, at least at the onset, maybe given enough time, he might improve his game to be competitive. But put him the pool, and he is unstoppable.
By trying to expand outside of his circle of competence, we get his comfort zone and away from what he knows best, the pool.
The same rules apply to investing, the ones that do the best tend to stay within areas they know best. Warren Buffett has areas he knows extremely well, such as insurance, retail, and financials.
Another story to relate how this can work outside of investing comes from Charlie Munger:
“You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.
If you want to be the best tennis player in the world, you may start out trying and soon find out that it’s hopeless—that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes the intelligence. But after a while, you’d gradually know all about the plumbing business in Bemidji and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence—which results partly from what they were born with and partly from what they slowly develop through work.”
Such simple, straightforward advice about living life, I wish I had learned to follow it earlier, it would have helped me avoid many mistakes in life.
Sherlock Holmes is quoted as saying:
“I consider that a man’s brain originally is like a little empty attic, and you have to stock it with such furniture as you choose.”
Despite being a genius, it was surprising what Sherlock Holmes didn’t know that lay outside of his work.
For example, when Dr. Watson talks to him about the solar system, he doesn’t know the stars, planets, and so on. And according to Holmes, it makes no difference to him in regards to solving mysteries.
Only what matters to him and his circle of competence is important to his work and passion.
Warren Buffett and the Circle of Competence
“Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management and limited exposure to hard times…Buy into a company because you want to own it, not because you want the stock to go up.”
Think of it this way.
As Buffett explains it, his strategy for avoiding problems is a two-part system. He knows his circle of competence, and more importantly, its boundaries, and he stays within those boundaries.
If there is one thing we can learn from Buffett and his investment strategies are that he only invests in businesses that fall within his circle of competence, and he rarely strays outside of that circle.
Recent developments aside, with his exiting airlines recently, as no one could have foreseen the coronavirus pandemic and the effects on the airline industry. He has stayed within his circle over the years.
Understanding our circle of competence completely is just as important to know what we don’t know as what we do. If I am struggling to get my grips on an industry or an idea, it is best that I just walk away.
As value investors, it is important to understand the business that we are buying because that is the goal, buying a business that will create value for us. If we don’t know how that business makes money, we will never truly understand the business.
Unlike with baseball, we don’t have to swing at every pitch that Mr. Market throws at us, we can wait for our pitch and then take our swing.
Even Peter Lynch talked about buying what you know in his book “One Up on Wall Street.” Lynch wasn’t referring to buying Starbucks because you love their coffee. Rather he was discussing buying businesses that you understand and can relate to their strengths and weaknesses as a business.
An example of this would be, if you are investing in banks, you must be knowledgeable about how a bank makes its money, and where their greatest risks for failure lie. Most laypeople think that a bank makes most of its money from the fees it charges customers, but in 99% of most cases, this is not correct, banks make their money from interest earned from credit products such as loans, mortgages, and credit cards.
Understanding where your circle of competence lies and staying within that realm can help you avoid mistakes and losing your capital permanently, which is rule number one.
Avoiding overreach is one of Buffett’s keys to his success when he has felt that investment was too tough; it went directly into the “too hard” pile, and he moved on to other companies.
Ok, let’s take a look at defining our circle of competence.
Defining Your Circle of Competence
What is inside our circle of competence? When we consider that question, a common behavioral bias pops up, overconfidence. Based on what we feel we are good at, we probably feel that our circle of competence is bigger than it is.
Not trying to slam anyone, I fall into this category myself. I will give you an example from my story. As a young man, I studied music and went to college, where I received a degree in jazz guitar. As a trained musician, I felt that I had learned as much theory and technique as I needed to make my way in the world of music.
One of my friends offered to take me to see B.B. King, the legendary blues musician at a local show. At first, I was reluctant because I felt that the blues was below me, and I only wanted to stretch myself as a musician. Well, needless to say, I was blown away by the level of musicianship and emotion that he displayed with his playing and singing.
I decided that I needed to learn how to play this music, and at first, I thought it would be easy because I was a trained guitar player. But as I learned very quickly, just because it was simple, didn’t make it easy. The music lay outside of my circle of competence, even though I thought it was because of my level of overconfidence.
So how do we define our circle of competence? By looking at three psychological definitions:
- Behavioral Comfort – If you are comfortable when deciding on buying a company, then you need to think about the additional decisions that come along, such as when to sell, how to anticipate future investments with the company when to make a larger commitment to the company. If those decisions make you uncomfortable, then maybe making the initial investment is not the right decision, and the company may fall outside of your circle.
- Inherent Predictability – Some businesses like Walmart are easier to predict, and it is easy to get caught up in the new, shiny objects that tech offers. But the future is uncertain, and it doesn’t matter how much expertise or experience you have, the future is unknown. Your comfort level with that uncertainty goes a long way towards understanding your circle of competence.
- Domain Expertise – If you are comfortable making an investment where the inherent predictability is unknown, and your sufficient domain expertise allows you some ability to understand and estimate what the future might hold for that investment. Domain expertise is where your time and effort of studying the industry will pay off.
Ok, let’s look at how we can expand our circle of competence.
Expanding Your Circle of Competence
Not everyone is born with an investment circle of competence, but it is a skill that we can learn over time.
Growing our circle of competence requires an equal dose of deserved confidence and humility. The confidence comes from learning, reading, studying the masters, and having successful investments.
Once you have completed some simple investments, you can choose whether you want to expand your circle, or stay within that current circle. There is nothing wrong with staying within that circle, there are many successful investors that stay within a narrow field of competence, and that is great.
Never feel pressured to invest outside of your circle; you will regret it, if not in the short-term, in the longer period as you expand without truly understanding the industry or company. And this could lead to losing your capital or even worse, never investing again.
Rather, if you wish to expand outside of your circle, it is certainly possible and definitely doable.
An example of a famous value investor who stepped outside his comfort zone to invest in the auto industry is Mohnish Pabrai.
Pabrai discovered a fantastic investment opportunity, but he knew nothing about the auto industry, so instead, he passed it by. Later he was presented with the same opportunity, and this time, it tweaked his interest.
Instead of just buying the company and rolling the dice, he decided to learn as much about the auto industry as he could. He started studying the industry, reading books, periodicals, industry reports, interviewing other investors in the space, talking with insiders in the industry. Basically, he immersed himself in the industry to learn as much as he could about the industry before deciding to buy any company in the industry.
Bottom line, all that hard work and effort paid off because he was able to invest in Fiat Chrysler, and the company has proved to be an incredible investment for Pabrai.
The take away from that story, find a passion, and follow it. If you are passionate about the beverage industry, then study the industry to become more knowledgeable about how the industry works and what success and failure look like in that field. Find others that share that passion and learn from them, study companies who specialize in beverages, maybe even work in the field to gain more insights.
I was lucky enough to work for Wells Fargo early in my investing career; it taught me an incredible amount about finance, credit, and how to read financials. I was lucky enough to find a great mentor who helped guide me and was a fantastic resource when I had questions.
Because of my experiences, it ignited a passion for banking and how they worked. I studied the industry and taught myself how they work, make money, and what kinds of banks would fit into my new circle of competence.
Bottom line, you can teach an old dog new tricks, and you can always learn something new and expand your circle of competence. I encourage you to look around you and find something that you are passionate about and explore. You never know what you may discover.
Discovering what our circle of competence is and where the edges are is instrumental to success in investing. Warren Buffett and Charlie Munger both introduced this idea to the investing world in the mid-90s.
Both Warren and Charlie have stayed within their investing career; if you study their portfolio over the last 30 years, it is a pretty narrow focus of industries. And they have had tremendous success with that narrower focus. But notice the branching out lately with the investment in Apple, which Buffett said he would never invest in technology because he didn’t understand the industry.
My advice is to spend some time thinking about where your circle of competence lies and explore the edges of the circle. Once you are comfortable with those edges, think about what areas ignite some excitement for you? Mine was financials like banks, insurance, and the Federal Reserve. Find your own, whether it be tech, retail, food, commodities, and embrace as much as you can about those fields.
That is going to wrap up our discussion for today, as always, thank you for taking the time to read this post.
I hope you find something of value to help you along your investing journey.
If you have any questions, please don’t hesitate to reach out.
Until next time.
Take care and be safe out there,