“You don't have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” -Warren Buffett (Trades, Portfolio).
The above quote from Warren Buffett (Trades, Portfolio) has been published and republished many times. The Oracle of Omaha's entire investment strategy is based on buying what you know and he has repeated this mantra over and over again.
But how do you go about finding what you know? Can the average investor, who does not invest full-time, realistically expect to build a circle of confidence for any specific industry?
Building a circle of competence
To answer this question, I thought I would take a look at how my investment strategy has evolved over the years.
For the first few years of my investment career, I didn't understand the "buy what you know" mentality. It took me some time to realize that this idea was not based on the notion that if you like Starbucks coffee, you should go out and buy Starbucks stock.
Over time, I came to realize that your circle of competence is not something that you can build quickly. Investors who have a background in a particular industry or managing a business have a critical advantage here.
If you have already managed a business, not only can you evaluate a stock from a business person's perspective, but if the company you are looking at operates in a similar industry to the one you have experienced, you have a unique perspective on what is going right or wrong for the business. It is true that most investors don't have this experience.
Indeed, even Warren Buffett (Trades, Portfolio) didn't have this experience when he first began investing and neither did I. Over the years, however, I have developed this experience by watching. The markets are, in my view, a giant learning machine. Every day, companies are announcing good news or bad news, and if you keep an eye on what is going on, you can build a rough metal model that gives you some guidance of what good and bad businesses look like.
This is not a quick process, and there's no shortcut. In my opinion, you need to be able to work out for yourself, which sectors and industries you are most interested in: There is no point in forcing yourself to try to understand something. If you don't understand specific sectors, there's no shame in avoiding them all together. Warren Buffett (Trades, Portfolio) avoided the tech sector for most of his career.Personally, I've always avoided the retail sector because I have never understood fashion.
Finding your niche is as much about discovering your preferences as an investor than anything else. At this point, if you feel overwhelmed or bored, it might be time to exit investing altogether. But if you find an industry you enjoy studying, then take it and run with it.
Once again, there are no shortcuts to this process. If you enjoy looking at an industry and figuring out how it works, you will be able to build up a picture of what it takes to succeed and what it takes to fail. Layering this focused understanding over a broader knowledge of general success and failure stories in business should help you build a robust circle of competence.
It's all about time and experience. No one will know everything about an industry overnight, and even those that do may still end up stumbling. Nevertheless, by taking the time to build a broad understanding of what works and what doesn't for all businesses and companies in a specific sector, you should be able to reduce your risk of failure dramatically.
Of course, the next stage is more company specific. If you find a company, you need to understand what makes the business tick and why it has an advantage over the rest of the industry.
A circle of competence is not a static idea. It is a continually evolving process. It needs to be nurtured, fed and grown to adapt to the changing market environment and different processes and catalysts that are out there shaping the business environment. You could even argue that a circle of competence is not limited to a specific sector. If you don't have a solid understanding of how businesses work, does that mean equities are outside of your circle of competence? I believe that could be the case. Some people just aren't suited to invest.
Disclosure: The author owns no stock mentioned.
