In a 1974 interview, Forbes Magazine asked Warren Buffett (Trades, Portfolio) what stocks he liked at the time. Buffett refused to give any names, saying that he didn't want to "tout my own stock," but he did offer some advice for investors looking for bargains:
"Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management and limited exposure to hard times...Buy into a company because you want to own it, not because you want the stock to go up."
This principle of investing inside your circle of competence has been a core idea for Buffett since the very beginning. Over the years, he has refined and developed his thoughts on the topic and offered more detail in interviews. For example, in an interview with Adam Smith in the mid-1980s, Buffett said:
"I don't know what the cocoa bean is going to do. There are kinds of things that I don't know about. And that may be too bad but why should I know about them? I haven't worked hard on them. In the securities business every day you have thousands of the major American corporations offered you at a price that changes daily and you don't have to make any decision. Nothing is forced upon you, so there are no called strikes in the business...They may be wonderful pitches to swing at but if you don't know anything about them, if you don't have to swing, and you can sit there and watch thousands of pitches, and finally got one right and you understand and then you swing."
Invest in companies you understand
If there's one thing we can learn from The Oracle of Omaha's investment strategy over the past five decades, it is the fact that he only likes to invest in companies that he understands.
It is amazing how many investors fail to follow this. Wave after wave of novice investors are quite happy to spend their life savings buying shares in highly speculative oil and gas stocks or precious metal miners, only to see their investments wiped out.
Even a qualified geologist pouring over the limited information that is provided to investors would only have a limited understanding of the company's potential, even if it was within their circle of competence There are thousands of different variables that could affect the eventual outcome, including but not limited to access to financing and management competence and availability of machinery.
Understand your circle of competence
To understand your circle of competence entirely, it is just as important to know what you don't know as clearly as what you do. If you are struggling to get to grips with an idea or industry, it is best to stay away.
Even if it looks like there's a fantastic bargain to be had, investors need to remember that there are always great opportunities in the stock market. You don't have to take every single opportunity that comes your way.
It is much better to wait for the right opportunity that you understand and go all in, rather than swing at every potential opportunity that comes your way.
Some of these will be successful, some won't, but there is no way of understanding which will be if you don't understand the company you're getting involved with. Buffett has become wealthy not by taking every opportunity, but by picking a select few.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Rare Early Interview From Warren Buffett
- Warren Buffett's 1974 Advice on Market Selloffs
- Warren Buffett: Cash Is King, Especially in Times of Crisis
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