Although the idea of the Circle of Competence is quite old, however, it was popularised by the billionaire investor Warren Buffet. Here’s one of his quotes regarding the circle of competence.
“What an investor need is the ability to correctly evaluate selected businesses. Note that word ‘selected’: 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 (1996 Letter to the shareholders)
In this post, we are going to understand what exactly Warren Buffett meant by the Circle of competence. Moreover, you’ll learn how by understanding the concept of the circle of competence, you can significantly improve your investment strategy and returns. Let’s get started.
What is the Circle of Competence?
“I’m no genius. I’m smart in spots-but I stay around those spots.” – Tom Watson Sr., Founder of IBM
Because of different background, qualification, or experience, everyone has built up a greater knowledge in a specific area. In this certain field, these people have the expertise and hence, have a significant advantage. This is called the circle of competence.
Further, the circle of competence might vary from people to people depending on the criteria mentioned above.
For example, a doctor might have expertise in medicines, healthcare or pharmaceutical and he can consider this area as his circle of competence (COC). However, if he also runs his family, which is involved in the banking industry and he might have acquired a good knowledge of that field (through his family background). In such a case, both pharma and the banking sector lies within his COC. In other words, he has a bigger circle of competence.
An important point to mention here is that your circle of competence need not only be related to the career that you are pursuing or the education/qualification that you have. It could be ‘anything’ that you have a good knowledge of.
However, it’s really important that you should define your circle of competence and understand to operate inside it. The problem arises only when you do not exactly know your circle of competence and unknowingly believe yourself as an expert and invests in something that’s outside your circle.
Why You Should Invest inside your Circle of competence?
“We have to deal in things that we are capable of understanding.” Charlie Munger
If you cannot understand a business, then you will not be able to evaluate it effectively. Investing in something which you do not have much knowledge will lead you to the wrong evaluation and overall, it will turn out to be a bad investment. Warren Buffett’s right hand, Charlie Munger always says that the investors who get outside their circle of competence find themselves in a lot of trouble later.
Although this sounds obvious and you might be thinking – “Why would I buy something that I do not understand?”. However, most investors are not much disciplined to invest inside their circle of competence. The temptation of investing in a ‘hot’ or popular stock where most of their friends are making money is too strong.
Anyways, as mentioned earlier, you need not be an expert in a lot of areas. Just stick to where you are good and avoid the areas where you do not have much expertise. By doing so, you can maximize your chances of success.
How can you widen your ‘Circle of Competence’?
If you think that your circle isn’t too big, do not worry. With time, you can work on it and expand your circle of competence. How? By continuously learning new things. Just Read, Read, Read!
That’s the only way how experts increase their circle of competence. In fact, even an engineer can have a circle of competence is the pharmaceutical sector if he starts reading regularly. Here’s a quote by Charlie Munger highlighting the importance of reading:
“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.” -Charlie Munger
Further, to end this post here is an amazing quote by Warren Buffett that you should take away with you.
“Everybody’s got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle.” – Warren Buffett
I hope this post is useful to you. If you’ve got any questions regarding the concept of the circle of competence, feel free to comment below. I’ll be glad to answer them. Take care and happy investing.