Warren Buffett and Charlie Munger are names that most savvy investors are aware of. Investors around the globe have been trying to replicate their portfolios on a smaller scale in an attempt to earn proportionate returns.
Unfortunately, many of them fail to get even close to replicating the returns. While the reasons can be many, investors often miss out on an important concept that ace investors like Buffett apply to their investment strategy- the Circle of Competence. Let’s learn more about this concept and its application in devising robust investment strategies. Read On!
The Circle of Competence is a very simple concept. If you do something without understanding it completely, then there is a higher chance of making a costly mistake. It’s common sense, isn’t it?
Let’s say that you work in the banking sector. Your understanding of the way the financial industry works will be based on your experience which will be stronger than someone who researches and tries to read about it online. Hence, when you invest in the financial sector, you are likely to make better decisions as opposed to someone from the textile industry who has read some articles about the sector online.
In today’s times, the perception of knowledge usually engulfs your true knowledge. Hence, our knowledge graph looks something like this :
As you can see, the circle of competency is the area that matches your experience and skills or ‘what you already know’. This concept first came to light in Warren Buffett’s letter to shareholders on behalf of Berkshire Hathaway. Here is a quote:
“Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs are 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.” – Warren Buffett
So, anything that falls within the realm of your acquired skill set, expertise, or experience, is said to fall within your circle of competence. Certainly, knowing your circle of competence increases your self-awareness as an investor, and can go a long way in helping you make smarter investment decisions. Let’s see some obvious advantages of investing within your circle of competence.
Here are some advantages of investing within your circle of competence:
As an investor, mistakes can be costly. Hence, reducing mistakes can help your investment portfolio to perform better. Over the years, I have found that most investors suffer losses in the stock markets not because they pick the wrong stocks, but because they pick stocks without understanding the business of the company.
Let’s take the example cited before:
You are a banker who decides to invest in the stock of an automobile company. However, your knowledge of the automobile sector is limited. Hence, you might decide to buy or sell the stock without completely understanding how the industry functions and if the long-term prospects are what you think. On the other hand, if you were to invest in the banking sector, then you would have a better idea about the performance of the sector and make better decisions.
If you invest within your circle of competence, you will have an advantage over investors who are stretching beyond the limits of their circle. In simpler terms, you play on your strengths, giving yourself a better chance of winning.
Successful investors reject stocks if they don’t fall within their circle of competence. And so, it narrows down the list of stocks that they need to choose from, making stock selection easier.
If you have read this far the next question to answer is how does one find their circle of competence?
Overconfidence is the biggest roadblock in identifying your circle of competence. What we ‘think’ we know usually overshadows what we actually know. Finding your circle of competence is not a difficult process. All it needs is clarity and honesty about what you know and invest accordingly while trying to widen the circle by acquiring knowledge.
Begin by listing down the number of industries or market segments that you understand thoroughly. You should understand the economics of the industry and the business. But, how would you know whether your knowledge of the industry or business is thorough? Check if you can answer all these questions:
Every industry has a unique way of functioning. Also, there can be times when a company decides to adopt a radical new method of operation contrary to what the industry follows.
So, before investing in any company, it is important to assess if you understand how the said company or industry works. How many revenue streams does it have? What are its standard processes and what variants are being adopted across the industry?
In simpler terms, you should be able to understand the business model of the company, as well as, its revenue streams.
Once you understand the business model of the company, ask yourself if you are aware of all the revenue streams of the company. What aspects determine the growth of the company?
Investing in a company without understanding its revenue model and growth factors can backfire. Once you understand this aspect, you will be in a better position to determine if the company can survive market competition.
Also, Read 5 Financial Ratios Every Stock Investor Should Know
This is an important aspect of any business. We live in a highly competitive world and any company that lacks the wherewithal to stand against the competition will perish in the long run.
Do you know if the company that you plan to invest in can withstand the pressure from competition or not? If yes, then what qualities help it fight competition from existing companies and new entrants?
Once you start looking at a company keeping your circle of competence in mind, you will have hundreds of questions like these. It might require some time, but eventually, you will gain clarity about the boundaries of your circle.
For some people, the reverse concept works too. They start looking at what they don’t understand and make a list of such industries or companies and avoid investing in them. Either way, the key to success lies in staying within the limits of your circle.
Also Read: The Concept of Economic Moat in Evaluating Stocks
Let’s say that you want to ensure that all your next stock purchase decisions fall within your circle of competence. How do you start?
Take a comprehensive list of stocks that you want to invest in. This can be based on any tip, suggestion, or even a raw data dump of stocks from the stock exchange.
Start looking at each stock and ask yourself the first question – do I understand how this business/industry works? If the answer is negative, then skip the stock. Go through the entire list and create two sub-lists – one for the businesses you understand and another for those you don’t.
Now, look at the businesses that you understand and ask yourself – do I know how this company makes its profits and grows? Do I understand the revenue model of the company? Follow the same ‘yes’ and ‘no’ approach as above and create sub-lists.
Take the list of businesses that pass the first two tests and go through their financial records. Can you understand the business thoroughly? You might have to use financial ratios to break the numbers down.
The final list of companies will be the ones within your circle of competence. Remember, even you have a handful of companies within your circle, there is no cause to worry. Identifying the boundaries of the circle is what helps to make sound investment decisions. Also, you can always gain knowledge about different industries and expand this circle.
Successful investors are excellent in understanding the boundaries of their circles and always stick to companies within the limits of their understanding. This approach can be highly instrumental in reducing mistakes made while choosing stocks for investment. If you are a novice investor and feel your circle of competence is small, to begin with, fret not!
You can always expand your knowledge and experience of a particular sector by being thorough with your research. Your circle will also expand as you start gaining more experience in the stock market. So start small, function within your circle of competence and work steadily towards pushing the boundaries slowly.