Whenever he is speaking about making a potential investment or describing the approach he uses when analyzing a company, Warren Buffett (Trades, Portfolio) always references his circle of competence.
I believe the circle of competence is one of the most misunderstood and overlooked aspects of investing. The reason is that it is so difficult for investors to define what their circle of competence is and, therefore, remain inside this invisible boundary.
For example, how do you determine what you do and do not know about and where do you place your limitations, which would act as the edge of your knowledge? You might think you know a lot about an industry, but do you really? Is that company that you think you know a lot about actually doing something that you don't understand and could, therefore, unseat your entire investment thesis?
Difficult to put into practice
Not only is it difficult to define your investment circle of competence, but it is also difficult to put it into practice.
If you invest only in companies that you know and understand, this will mean in reality, you will make very few investments (at least that is true of the individual investor). There is only so much you can know about industries and sectors, and I would be willing to bet that most investors, including myself, overstate what they think they know about particular industries.
So, you have to learn to sit on your hands when there are no attractive opportunities available in the market within your circle of competence. The hard part is sitting on your hands and not doing anything. It is straightforward to get distracted by companies in different sectors and industries that might fall outside your circle of competence just because they look cheap.
This is one of the reasons why Warren Buffett (Trades, Portfolio) is such a great investor. He is very capable of sitting on his hands and waiting for the right opportunity to emerge, ignoring all investments that he does not understand. This comes with another problem: the problem of diversification. If your circle of competence is confined to one specific sector or industry, you are not going to have a very diversified portfolio. You could argue that doing the research is enough to justify not being overly diversified, which is true to a certain extent, but it does not eliminate sector-specific risks.
No short cut
This is why the circle of confidence is one of the most complex and difficult-to-understand topics in investing. Not only can you not quantitatively define your circle of competence, but it is also fluid. Industries change, develop and evolve. Just because you understood the financial services sector 12 years ago does not mean that you will today.
To conclude, I want to add a simple guide for how readers can develop their own circle of competence to avoid all of the pitfalls mentioned above.
I would love to, but I can't. And I think it is impossible to do so.
Defining a circle of competence is never going to be easy because of its fluid nature, although, if we flip the question on its head, it is easy to understand what falls outside your circle of competence.
That's the summary I will use to conclude. While it is difficult and probably impossible to define precisely what your circle of competence is, it is much easier to avoid what you do not understand.
Disclosure: The author owns no share mentioned.
Read more here:Â
Sequoia Fund: The 4 Qualities to Look for in a StockÂ
Buffett: We Don't Buy Anything 'Just by the Numbers'Â
Warren Buffett on Calculating Prices for Wonderful BusinessesÂ
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