There are things we know, things we don’t know and the things we don’t know we don’t know. As humans we aren’t expected to know everything. The things we know well are what define our ‘Circle of Competence’. In the world of investing, we can avoid a lot of big mistakes by only investing in the businesses we fully understand. Speculating on something we don’t understand can be disastrous, all though it might look very promising initially.
The mental model of “Circle of Competence” has been mentioned by Warren Buffett and Charlie Munger a number of times in the past and particularly in the 1996 Shareholder letter in which Buffett said, “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.”
To do that, we need to determine our circle of competence and stick to it. Although it might seem obvious that investors should stick to what they know, the temptation to step outside one’s circle of competence can be strong. During the technology stock mania of 1999, Berkshire’s return badly trailed the market’s return, and a number of observers commented that Buffett was hopelessly behind the times for avoiding technology stocks
However, Buffett had written that he isn’t bothered when he misses out on big returns in areas he doesn’t understand, because investors can do very well by simply avoiding big mistakes (We know the aftermath of the tech bubble). He believes that what counts most for investors is not so much what they know, but how realistically they can define what they don’t know.
In one of the interviews, he has given an analogy of the baseball game and the concept of ‘Science of hitting’. It shows a striker holding the bat and a strike zone broken into 77 squares. In that entire strike zone, there is a defined sweet spot comprising of a few squares. If you hit the ball there, the maximum momentum will be transferred to the ball rather than being transferred into wasted vibrational energy that will shake the bat like crazy.
Investing is all about being in the best business you can be in. You can be looking at thousands of companies and you don’t have to be right on every one of them or even fifty of them. It is a game where you have to see pitch after pitch go by and wait for the one right opportunity to swing the bat (Invest).
Each individual has to define his own circle of competence and operate within that, undistracted by the noise around.
Having said that, operating inside our circle of competence in no way means that we should let it remain static forever. Instead, we should always strive to expand it leading to more opportunities come our way and greatly improving our odds of success. Warren Buffett was known for his aversion to technology stocks because he said that he didn’t understand technology. Today approximately 40% of Berkshire’s stock portfolio is invested in the technology giant ‘Apple’.
Finally, I would like to summarise this article in three key points:
- Know your circle of competence
- Operate strictly within it.
- Be a life long learner. (Warren Buffet, one of the richest people on the planet, at the age of 90, still spends most of his time at office, reading)
I can’t resist but quote Charlie Munger- “Humility means you know the edge of your competency and you aren’t arrogantly over the boundary. But within my circle of competency my best friend would not adore me for my humility.”