“I’m no genius. I’m smart in spots—but I stay around those spots."
— Tom Watson Sr., Founder of IBM
The circle of competence is a mental model coined by Warren Buffett that involves developing knowledge of specific areas an individual has an understanding of or experience in. These are the areas where individuals have an upper hand usually. Everyone has built up useful knowledge in some area of the world, but realizing those few strengths can indicate areas where you have very little familiarity and avoid them to mitigate risk.
Warren Buffet and his right-hand man Charlie Munger based this solely on how investors should make decisions. People should limit their investing decisions based on their boundary of knowledge as this would help investors evaluate in areas they know best, therefore, increasing their success rates by improving their agenda and their “subject matter expertise”. The other benefit you get by staying within is you can reduce risk by analyzing and assessing companies and their performance.
Charlie Munger stated, “It is really important to stay within your circle of competence. If you are not sure what the boundaries of that circle are for you, then you do not have real mastery of your field.” Investors should understand their boundaries and focus on what they know and use that as an advantage to achieve long-term success.
Why is having a Circle of Competence important for investors?
The circle of competence has many advantages for an investor, the main one is the avoidance of costly mistakes. Not every investment decision you make is going to work out perfectly, but by staying within your circle of competence you can lessen the risk of massive losses. You enter every decision armed with knowledge and backed up by experience in that particular field. Both of these make decisions a lot more informed and easier to make.
The other advantage is the opportunity to turn your knowledge into results. By understanding your circle of competence, you can leverage this to make informed decisions about investments, assess every inch of the company and industry, and proceed to invest. For example, if you have expertise in investing in the service sector, then you should primarily focus on investing in the service sector and not any other sector where you have significantly a lesser edge over others.
To conclude, Buffett’s strategy to avoid problems in investing is fairly simple. It’s a two-step process: firstly, know your circle of competence, especially its boundaries, and secondly, stick within it. If you want to venture out, do it slowly after achieving your foremost goal.
“You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence. The size of that circle is not very important; however, knowing its boundaries is vital.”
-Charlie Munger
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