Warren Buffett (Trades, Portfolio)'s circle of competence principle is one of the most valuable principles of investing. However, it is pretty challenging to explain what a circle of competence is and why it is crucial.
What is a circle of competence?
In its simplest iteration, the circle of competence is what an investor knows and understands really well.
That's easier said than done. It's straightforward for one to say they know a sector or industry well after a few hours of reading on the topic, but that won't provide the sorts of insights an insider might have.
Even insiders who have worked in an industry for decades may not be good investors because their own views may cloud their insight. For example, an oil industry executive who has worked in the industry for several decades at companies specializing in offshore drilling may have a detailed understanding of how offshore drilling works but may not understand the intricacies of the shale oil business.
Unfortunately, it would be straightforward for the executive to say they understand shale oil just because they have experience in the oil industry in general. The point is, understanding how the circle of competence works and where one's circle of competence lives is vitally important. It's even more critical that we are honest with ourselves when establishing what we do and don't know.
It's also important to acknowledge that we don't have to know everything to be successful as investors. It is possible to have a very narrow circle of competence and still do well.
Investors don't have to know everything
As part of a Q&A session with students of the Indiana University Kelley School of Business at the beginning of this month, Mohnish Pabrai (Trades, Portfolio) spoke at length about this concept.
The value investor gave the example of one of Charlie Munger (Trades, Portfolio)'s friends, John Ariega, "who only invests in real estate within two miles of the Stanford campus."
Pabrai explained that this man had become a billionaire through his real estate investing, and he had done so by investing in real estate in a "very specific geography." Some investors might view his portfolio of real estate assets as incredibly concentrated, "but that has not stopped him from doing extremely well."
When he was asked how could investors would know if something falls inside of their circle of competence, Pabrai replied:
"If you find yourself asking yourself the question, 'is this within my circle of competence?', I can just make you very quick for you. It is not. If you find yourself asking the question, 'what is this business worth?', again, it's not within your circle of competence."
He went on to explain that if a company falls inside an investor's circle of competence, "you would know the two or three variables that would drive most of the outcome in the long term."
These variables would be immediately apparent, and one would not have to question what they are before investing if the opportunity fell squarely in the center of one's circle of competence. The value investor went on to explain:
"It is very important to stay dead center in your circle of competence. Usually, there is not a clear boundary between competence and incompetence. So, as you move away from the center the degree of confidence goes down and the risk factors of investing in those businesses go up."
As such, the critical takeaway is that it is best to stay as close as possible to the center of your circle of competence. That way, one will not have to ask if something is in or outside the circle. It will always be clear. We don't need to understand everything in life to do well.
Disclosure: The author owns no share mentioned.
Read more here:
- David Einhorn's Favorite Value Investment Appears to Be Cheap
- Li Lu's Advice for Becoming a Good Investor
- Li Lu Explains Why Chinese Equities Are So Attractive
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