Every value investor should know their circle of competence. It is the area of expertise that is unique to each person. Understanding the circle will help you concentrate on areas that give you the most significant investing average. The size of the circle is not important; it is knowing where the edge is and keeping inside of it.
Your circle of competence is the knowledge, experience, and wisdom unique to you. It is what you know and understand the most. If you have worked for an extended period in a particular industry or believe in a specific company’s products and services, chances are it is in your circle of competence.
What is the circle of competence?
Every person on this planet has experiences and knowledge unique to them. Each piece of expertise gained from studying at school, work experience, or just life wisdom creates a tool kit for navigating life. This combination of the tools may best serve certain areas while inadequate in other areas. In investing, it is essential to understand a business before investing in it. You must know how it makes money, the strengths and weaknesses of its competitors, its management’s abilities, and its competitive advantage. Knowing what businesses you understand and do not understand is essential to making successful investments. Stepping outside of your area of expertise significantly increases the chances of failure.
Inner, middle, and outer circle
The circle can be thought of as having an inner, middle, and outer circle. The inner circle is your true circle of competence, which includes business that you can thoroughly understand. As mentioned, it is not the size of the circle is not important, knowing where the boundary is. The more experience you gain, the larger this circle expands.
The middle circle is the most dangerous area. It involves companies you know something about but not enough to understand it deeply. This is where many investors get into trouble because they can become complacent about the amount of expertise they have about a company. For example, an investor may have read a company’s financials, but they may not know how good the management is at decision-making. And it is the company’s management that can make or break a business. When looking for investments, it is best to try to discard the opportunity then try to look for reasons to invest. By eliminating 99% of available opportunities, the investor can focus on the handful of companies they are deeply knowledgeable about. Investors may be successful in the short term by investing in the middle circle, but the probability of success declines over the long term.
The outer circle includes the companies you know nothing about. These companies are the easiest to discard as they are often the most complicated. For example, how many investors have a deep understanding of pharmaceuticals? And even if they are knowledgeable in pharmaceuticals, they will need extensive knowledge of the particular class of drugs.
Finding your circle of competence
Your circle of competence is the area of interest you have a deep understanding of. You can look at your work experience, the products, services you use regularly, or even your hobbies to find it. For example, if you have been working in the semiconductor manufacturing business for decades, you know what the best company is and how likely it will stay the best company. A good indication of your level of knowledge is if you would be able to talk at length about the industry if asked. To determine how much you know about a company, you will need to understand its competitive advantage, the strength of its competitors, the competency of its management, its rate of innovation, cost drivers, growth drivers, and risks associated with investing in the company.
What you think is in your circle is most likely less than what is inside it. Multiple human psychological biases can mislead investors into thinking they know more than they do. Even if investors are highly knowledgeable about an industry, they may still have negative behavioral tendencies, miscalculations, and blind spots. For example, they may be subject to confirmation bias, which is the tendency to search for information that supports our opinion and reject any contrary information. Investors must look at all info objectively if they are to be successful. There may also be a miscalculation in probabilistic thinking, which helps investors calculate the chance of losses in investments. This is particularly important as the number 1 rule of investing is not to lose money, and investment risk is defined as the chance of permanent capital loss. It is one of the best tools for estimating our chance of success.
Expanding your circle of competence
As you progress through life, you will naturally expand your circle of competence just by being exposed to different experiences and reading various literature. However, it is possible to expand your circle of competence actively. One way to expand your circle of competence is to spend time researching and reading all of a company’s financial statements, speaking to its employees, or being a user of its products and services. Starting with companies in industries you already have some knowledge of improves your chance of success. For example, if you know a lot about the coal industry, it is not too much of a stretch to learn about the precious metals industry. Expanding your circle of competence takes time, patience, and persistence. It requires lifelong learning and reflection on mistakes.
However, it is not imperative to expand your circle of competence; you can be a very successful investor knowing a lot about a small niche. For example, John Arrillaga is a billionaire real estate investor who made his fortune by only investing within five blocks of the Stanford University campus. Your passion can be a good indication of where you are likely to remain engaged for an extended period. While cloning other investors is a good strategy, you must deeply understand the company. Investing in an insurance company just because Warren Buffett does may not be a bad investment. Still, if you could not think of anything duller than insurance, you will unlikely remain focused long enough to understand the business.
