At the 2006 Berkshire Hathaway (BRK.A)(BRK.B) Annual Meeting, a shareholder asked Warren and Charlie to dive deeper into their thoughts on an individual’s circle of competence; here is what they had to say (with emphasis added):
Warren: “We are best at evaluating businesses where we can come to a judgment that they will look a lot like they do now in five years. The businesses will change, but the fundamentals won’t. Iscar will be better – maybe a lot bigger – in five years, but the fundamentals will be the same…
Charlie says we have three boxes: “In,” “Out” and “Too hard.” You don’t have to do everything well. At the Olympics, if you run the 100 meters well, you don’t have to do the shot put…
Tom Watson [the founder of IBM] said, “I’m no genius. I’m smart in spots and I stay around those spots.” We have a lot of managers who are the same. You don’t want to compete with Pete Liegl [the CEO of Forest River; Warren made an offer for the company in 2005 one day after learning about it] because he’ll kill you in the RV business. But he doesn’t try to tell us how to run the insurance business…”
Charlie: “We know the edge of our competency better than most. That’s a very worthwhile thing. It’s not a competency if you don’t know the edge of it.”
In an interview with GuruFocus(here), Peter Bevelin, author of “Seeking Wisdom: From Darwin to Munger,” had this to say when he was asked about the importance of skepticism and how it relates to avoiding mistakes:
“Generally, keep it simple and use some filters. Some questions I ask myself: Is it important? If yes, is it knowable? If yes, is this within my circle of competence? Which of course assumes that I know what I know and can do, and what I don’t know and can’t do; otherwise, I exclude [it] and throw it in to too hard pile.”
I think this is particularly relevant because we live in a world where investors are baited to trade, rather than invest; the question isn’t generally posed as whether one should act, but rather as whether one should go long or short, regardless of their actual understanding of the valuation, fundamentals, business model, or a plethora of other concerns.
In a lot of ways, this is only natural; it’s almost a gut response to start spewing you opinion on a stock when someone asks, regardless of how much you actually know about the company or the industry. The best example of late is Bank of America (BAC); in the past year, you couldn’t go a week without hearing about the merits of BAC common and why you HAD to buy it.
Even for people who knew that it was in the “too hard” pile (like me), there was still a desire to do something, anything; there was a potential to make money, and that is all it takes to get the heart pumping. As I noted in my article entitled “Peter Lynch’s Two Minute Drill” (here), this is due to our wiring:
When sizing up a potential investment, the “reward system” within our brains is fraught with activity in anticipation of what might be; as neuroimaging scans have shown, this feeling is created by increased levels of the chemical dopamine in the brain. Harvard researchers have found that this feeling among investors is “strikingly” similar to the brains of cocaine addicts and morphine users in anticipation of their next score.
Interestingly, neuroimaging studies show that receiving a reward (achieving the gains) is not as satisfying as the anticipation; in fact, when the reward is less likely (for example, buying the BAC “lottery ticket” at ½ of tangible book), the more active your dopamine neurons are, leaving you with a feeling of pleasure and an attraction to taking risks. As noted by Jason Zweig in a 2002 article on the subject, “Dopamine makes winning big feel vastly better than just winning — and the prospect of its euphoric effect prevents us from focusing on how small the odds of winning big actually are.”
Today, BAC sits at $7.85, and is roughly 60% above the lows reached at the end of last year; however, for investors who bought it in early 2010 in the low-mid teens, they are still a long ways away from breaking even. This isn’t to say that buying BAC was a bad investment; as I noted, it’s in my “too hard” pile, and may prove to be an intelligent decision over time. The purpose is to point out that when investors stray from their circle of competence, they put themselves in a position to act emotionally, and dramatically increase their chances of making a poor decision (many sold out due to the fear of the unknown as the stock continued to fall; unfortunately, an empathy gap makes it easy to overlook the potential of this outcome when we’re salivating at the possibility of sizable returns).
Nine times out of ten, investors venture into the “too hard” section with the hope of huge returns; the focus on risk and capital preservation flies out the window, as prudence is replaced by the hope of a quick double. Unfortunately, an inability to accurately predict intrinsic value makes committing capital as the price declines an increasingly difficult decision: If Procter & Gamble (PG) or Coca-Cola (KO) fell 15-20% next week, most value investors would love to buy more, but for those who held BAC in August 2010 and watched it fall 33% in six short days, it probably felt more like a disaster than an opportunity.
For the intelligent investor, there’s a simple solution: Set aside 3-5% of your portfolio for the high fliers that feed your speculative desires, and keep the remainder of your hard earned capital in actual investments. By limiting your exposure to the “too hard” parts of the market, you can maintain a sense of focus on a prudent investment strategy while still getting exposure to the world of cloud computing and financials, or whatever it may be that’s mysterious, unknown, and keeping you up at night in fear of missing out (if you must); most importantly, you can still sleep tight knowing that 95% of your savings is devoted to a collection of businesses that will carry the weight of the portfolio, and will look similar five, ten, and fifty years down the road.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.