A lot of times we take the phrase "circle of competence" for granted, but how do Warren Buffett and Charlie Munger explain them and how can we apply them to our investing ideas?
During the 2006 Berkshire Annual Meeting, an investor asked, and he received the following answer:
Buffett: 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. In contrast, look at how much telecom has changed.
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 [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 Inc.) because he’ll kill you in the RV business. But he doesn’t try to tell us how to run the insurance business.
I was virtually there at the birth of Intel (INTC). I was on the board of Grinnell College with Bob Noyce, and Grinnell invested $300,000 into it at inception. I easily could have as well, but I had no idea then and still don’t now what Intel will look like in five years. Even people in the industry don’t. Some businesses are very, very hard to predict.
Munger: A foreign correspondent, after talking to me for a while, once said: “You don’t seem smart enough to be so good at what you’re doing. Do you have an explanation?”
Buffett: Was he referring to me or you?
Munger: I said, “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.
So basically, the circle of competence is that knowledge of a certain industry or business that allows you to predict, with a certain degree of accuracy, how the dynamics of competition will turn out and translate into results in a few years. While this looks fairly simple, it is important to remember how fast industries change and develop, leaving our previously accepted ways and products obsolete.
The inception of one's circle of competence generally has something to do with what we decided to study and/or the area at which we started working. This exposure provides an important advantage against someone who is starting fresh in his understanding of the industry.
Also, it is important to remember that the more basic knowledge we have, that is from the main sciences, the easier it becomes for us to grasp concepts across new areas. A circle of competence can certainlyÂ beÂ expanded, but generally the theoretical learning should be accompanied by some experience to reap the most benefits.
To invest successfully, it is not critical to know a bit about everything, but to know a great deal about certain topics and, most importantly, define the boundaries of that knowledge, in spite of other people's successes. Envy and jealousy can get us into a lot of trouble, and sometimes, when everyone is getting rich, there is a tendency for us to step out of our circle of competence to match their results. This has proven unsuccessful to many investors, but successful to others such as Buffett and Munger, who had the discipline to save bullets instead of stepping outside their circle of competence during the dot-com bubble. By staying inside, we are more likely to obtain advantages and better investment results.