Why Should You Invest Inside Your- Circle of Competence?
“We have to deal in things that we are capable of understanding.” Charlie Munger
The idea of the Circle of Competence is quite old. Although, it was popularised by the billionaire investor Warren Buffet, however, you can find a number of experts speaking about it.
Here are the quotes by few of the famous experts around the world:
“What an investor need 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.”
-Warren Buffett (1996 Shareholder Letter)
“I’m no genius. I’m smart in spots-but I stay around those spots.”
– Tom Watson Sr., Founder of IBM
“Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly.”
– Charlie Munger
What is the Circle of Competence?
Because of different background, qualification, or experience, everyone has built up a greater knowledge in a specific area. In this certain field, these people have an expertise and hence, have a significant advantage. This is called the circle of competence.
The circle of competence might vary from people to people depending on the criteria mentioned above.
For example, a doctor might have an expertise in medicines, healthcare or pharmaceutical and he can consider this area as his circle of competence (COC). However, if his family is involved in a banking business and he has acquired a good knowledge of that field (through his family background), then the banking sector also lies within his COC. He has a bigger circle of competence.
In short, your circle of competence need not only be related to the career that you are pursuing or the qualification that you have. It could be ‘anywhere’ which you have a good knowledge of.
However, it’s really important that you should define your circle of competence and understand to operate inside it. The problem arises only when you do not know what your circle of competence and unknowingly invests in something that’s outside your circle.
Why Circle of Competence?
If you cannot understand a business, then do not evaluate it. Investing in something which you do not have much knowledge will lead you to the wrong evaluation and overall, it will turn out to be a bad investment.
Charlie Munger says that the investors who get outside their circle of competence find themselves in a lot of trouble later.
Although this sounds obvious and you might be thinking – “Why would I buy something that I do not understand?”. However, most investors are not so much disciplined to invest inside their circle of competence. The temptation of investing in a ‘hot’ stock where most of their friends are making money is too strong.
Further, you need not be an expert in a lot of areas. Just stick to where you are the best and avoid the areas where you do not have much expertise. By doing so, you can maximize your chances of success.
How can you widen your ‘Circle of Competence’?
Nevertheless, do not worry, if you think that your circle isn’t too big. With time, you can work on it and expand your circle of competence.
By learning continuously! Read, Read, Read!
That’s the only way how experts increase their COC. Here’s a quote by Charlie Munger highlighting the importance of reading:
“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.” -Charlie Munger
That’s it. Here’s a quick tip- Even an engineer can have a circle of competence is the pharmaceutical sector if he starts reading regularly.
Further, to end this post here is an amazing quote from Charlie Munger that you should take away with you-
“You don’t have to pee on an electric fence to learn not to do it. Learning from other people’s mistakes is much more pleasant. The best way to do this is simple: When in doubt, read so you can learn vicariously.”
I hope this post is useful to you. Happy Investing.
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Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst. I’m 23-year old and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting