Warren Buffett (Trades, Portfolio), likely one of the most quoted men in history – and for good reason – said, "Everybody's got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle."
So, what does this mean?
The "circle of competence" concept refers to the realm of knowledge and expertise that an investor has built up over time. We all have areas we understand well and others that are out of our depth. As Buffett, the CEO of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), advises, the key is to identify the boundaries of your own competence and stick within them when investing.
Understanding your circle of competence
The first step is honestly assessing what your circle of competence entails. As Munger, the vice chairman of Berkshire Hathaway, stated, "You have to figure out what your own aptitudes are." Take an inventory of your knowledge, skills and expertise. Be truthful about what you understand well and where you are ignorant.
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.
Applying your circle of competence
For example, if you worked in consumer goods, you would have strong knowledge of that industry. But you may have little insight into biotech. So, you need to shape your investments around what you know.
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.
The key is humility and honesty. Buffett advised, "Know where the line is between what you know and don't know." Don't let your ego lead you astray.
Identifying your edge
Once you know your circle, identify where you have an edge compared to Wall Street. As Lynch said, "Never invest in any idea you can't illustrate with a crayon." Find simple businesses you grasp.
Look for niches tied to your expertise where professionals are overlooking opportunities. For example, maybe you're an avid video gamer with your finger on the pulse of that industry. Or you're a retailer familiar with customer shopping patterns. Leverage this specialized insight.
Capitalizing on your circle of competence
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.
And, as Lynch highlighted, "Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it."
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."
Don't invest in businesses you simply do not understand. Buffett advised, "Stay away from things you don't know about." No matter how tempting the potential returns look, ignore opportunities outside your expertise.
Ignoring hype and speculation
A key pillar of this is tuning out hype and speculation. If everyone is buzzing about an industry you do not know, avoid the noise. Buffett and Munger ignored the mania around internet stocks in the 1990s for this reason.
As 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.
Emphasizing continuous learning
While you should avoid what you don't know now, you can steadily expand your competence circle through continuous learning. As Munger noted, "You've got to stretch the boundary by working at it."
Read widely to gain knowledge across a range of industries and sectors. Develop more profound expertise in your chosen specialties, and learn from others whose competence differs from yours.
Expanding your circle of competence
Buffett and Munger exemplify this constant hunger for knowledge. Despite being in his early 90s, Buffett still spends much of his day reading. Munger offsets Buffett's core consumer goods and insurance competencies with his law and banking expertise.
Make learning a lifelong endeavor. Be patient in broadening your competence circle. Mastering new areas doesn't happen overnight, but steady investment in knowledge will widen your investing horizons.
As Buffett said, "The wider your circle of competence, the better your results will be." Never stop pushing to expand what you comprehend.
The benefits of staying inside your circle
Abiding by your circle of competence offers many advantages:
- Greater odds of success: You maximize gains by focusing only on what you truly grasp. Avoiding speculation and unknowns prevents costly mistakes.
- Confidence: You make moves with conviction, not questioning your rationale. There are no second guesses when operating in your wheelhouse.
- Less risk: Sticking with what you know reduces your chance of permanent loss. Unknowns bring unforeseen risks. Avoiding them eases volatility.
- Better decisions: Your choices are based on real knowledge versus speculation. Facts trump hype within your expertise.
- Faster learning: Mastering new areas is easier when you have a baseline understanding. You build on your current competencies.
- Innovation: Expertise fosters creative new ideas. Real change comes from deep knowledge.
But most of all, restricting your investing to your proven competencies gives you peace of mind. As Buffett said, "You don't have to really think. It's automatic. It's just like breathing. If it's in your circle of competence, you hardly have to think about it." Confidence in your decisions lets you rest easy.
Avoiding common mistakes
While the value of staying inside your circle of competence is clear, it's easy to stray across the line. Watch out for these common traps:
- Ego: Overconfidence in your own abilities can cloud an honest assessment. Always stay humble.
- Greed: Allowing desire for profits to override your better judgment. Skepticism beats wishful thinking.
- Excitement: Getting swept up in enthused stories or hyped trends you don't truly grasp. Keep perspective.
- Peer pressure: Investing outside your competency to match what others are doing. Trust your own knowledge.
- Laziness: Failing to put in the work to expand your circle at a judicious pace. Learning requires effort.
Guiding your investing journey with expertise
The circle of competence concept is profoundly simple yet immensely powerful. It's no surprise Buffett, Munger and Lynch credit it as a bedrock of their success. They built fortunes by mastering their expertise spheres.
Trust that adhering to this principle in your own investing will put you on the path to prosperity as well. Define where your skills and knowledge shine, and stay within that arena.
Let your competencies be your guide. Resist the temptation to overreach. Learn, but do so intelligently. Setting these boundaries may seem limiting, but it gives you the freedom to make informed decisions with conviction.
As Buffett said, "The size of that circle is not very important; knowing its boundaries, however, is vital." Keep this simple rule at the core of your investing foundation.
