Circle of Competence- A Mental Model To Avoid Disasters In Investing

June 4, 2020

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Strategic Alpha

Understanding your Circle of Competence

Over the past 10+ years, I’ve researched and built up a base of companies that are in the business which I understand well and would like to own at the right value (aka Value Investing). I tend to stay within this small circle of companies. It’s rare for me to buy a company that I haven’t researched exhaustively for years; I like to stick to what I know.

Your circle of competence is the subject area that matches your skills and expertise. And understanding your own helps you concentrate on the areas where you have the greatest familiarity. It also helps you align a subjective assessment of your own competence with your actual competence.

The concept of the “Circle of Competence” has been used over the years by Buffett and Munger as a way to focus investors on only operating in areas they knew best. The concept appeared in their 1996 Shareholder:-

“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”.

Think of it this way:

Warren Buffett has said: “Know your circle of competence and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital.” The size of the circle does not matter, what matters is how well we stick within it. Keeping strictly to their own circles is what makes Buffett and Munger among the most successful investors in history. They stick to what they know. Their firm, Berkshire Hathaway, currently boasts more than $700 billion in assets.

“You have to be an expert in what you invest in.  You need to understand why you are invested. If you don’t understand why you are in a trade, you won’t understand the right time to sell, which means you will only sell when the price action scares you.  Most of the time when the price action scares you, it is a buying opportunity, not a sell indicator.”

The Circle of Competence is a model countless entrepreneurs have used, whether they know it or not. Here are a few ways I’ve used this model — and some advice: Find an area you are passionate about and go with it. I’ve recognized that I can provide value in the mentorship space (particularly investment research and stock selection) I’m hugely passionate about this area and I think that’s part of the reason I’ve seen success.

A view of a Low Downside and a Big Upside Munger do not like situations where there is a “close” investment decision to make.

“There are a lot of things we pass on. We have three baskets:  in, out, and too tough. We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.” 

People who know me know I’ve learned a lot from Charlie Munger and Warren Buffett. I particularly admire their mental model known as the Circle of Competence. Andrew Carnegie, potentially the originator of the idea, went so far as to encourage his mentees to not only concentrate all of their time and attention within one’s own circle of competence but to invest every dollar of their own wealth into it. This explains Carnegie’s hawk-like focus on the iron and steel industries.

Buffett and Munger initially developed the Circle of Competence to limit where to make financial investments (based on their own understanding and experience). But I’ve found the model to be useful in all areas of life. The idea is to understand where you’re naturally strong and stay within that area.

If you want to improve your chances of success in business and life then define your circle of competence, and operate strictly inside. Here’s how you can best describe it: A business is ‘within’ your circle of competence if you fully understand the underlying aspects of it: How it works? How does it manage its raw material costs? What drives its growth? What makes it profitable? How does it stand against its competitors? Whenever you invest in a stock industry or sector company and promoters are the things to look for. It is a very good idea to stay away from any business, sector or industry which you do not understand. Find such businesses or companies that best fit your understanding.

Learn Continuously:  Read, Read, Read

“You don’t have to pee on an electric fence to learn not to do it,” said Munger on one occasion.  At the most recent Berkshire meeting, he quipped: “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.  Charlie loves to talk about the importance of reading.

All the best for your future investments, Cheers!!

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The author of the blog Mr.Suyog Dhavan is a Full-time Investor / Value Trader and Value investing/Trading Mentor. His style of Investing is inspired by Mohnish Pabrai, Peter Lynch, and Porinju Veliath. He is the founder of Strategic Alpha Wealth, A Premier stock market mentorship firm with a mission to touch the lives of 1Lakh people through its mentorship program.

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