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How to Create Your Circle of Incompetence

One of the oft-asked questions in my Art of Investing Workshops is…

“How can a small investor create his circle of competence?”

This is a very important question, because “circle of competence” is in itself one of the most important facets of successful investing.

Anyways, tribesmen who have attended my Workshops (and I will let the secret out for tribesmen who are going to attend the upcoming Workshop in Mumbai :-)) know that my answer to this question is – Know your circle of “incompetence”.

Circle of incompetence?
First, let me touch upon on the meaning of “circle of competence”.

This concept, as popularized by Warren Buffett, states that investors should limit their investments to industries or areas where they know more than the average investor.

This is a very basic principle that simply says – don’t invest in what you know nothing about.

In other words, invest in only what you know.

Now, if someone asked me what my circle of competence is, I would find it very hard to answer, except that, in my experience as an analyst, I have studied companies from industries like technology, telecom, power, capital goods, automobiles, and FMCG.

I also know about these industries for I have been a consumer of their products and services for long.

But if you were to ask me about the oil and gas sector or pharma sector, while I have consumed fuel (for my car, of course) and medicines, I have no real clue about how a drilling rig works, how does crude oil looks like, or how do companies find new drugs.

I also don’t know what lies inside a bank’s balance sheet, or how to read balance sheets of real estate companies – simply because I don’t know what’s real in them and what’s fake.

In short, I have created for myself a circle of “incompetence” as far as industries are concerned.

Then, I don’t know how to deal in special situations, event-driven investing, cyclical stocks, or F&O. In fact, I have deliberately kept out of these given the high amount of stress involved for every unit of potential return.

These are thus also part of my circle of incompetence.

Now you may have a question – “Why create a circle of incompetence when creating a circle of competence seems easier?”

Well, this is because I find some intrinsic limitations to the circle of competence concept.

I am not so sure how a small investor, who is generally busy focusing on industries he already knows well – one he works for and a few whose products or services he consumes – can expand that circle of competence.

I also don’t know how a small investor can really prove to himself that he’s truly competent in a given area.

But when I read Charlie Munger reiterating Jacobi – Invert! Always invert! – I know there’s another way (then picking what you know) to create your circle of competence.

That way is to know things you don’t know and then draw a circle that keeps those things out.

First, know things you don’t know
This is very much what scientists do. They approach a problem and its solution by trying to prove it is false, not that it is true.

So, if you know things you don’t know – your circle of incompetence – you will automatically get to what you know – your circle of competence.

You may wonder, “Vishal, if I do what you suggest, I will be left with a very small circle of competence simply because I don’t know so many things!”

Well, in that case, it is important to remember what Warren Buffett wrote in his 1996 letter to shareholders…

Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs 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.

How I draw my circles
Here is what I have started doing as far as my circles of competence and incompetence are concerned.

I don’t approach any company or industry from a position of confidence.

So, instead of saying, “Hey, I know this company and industry,” I tell myself, “Let me start looking at this company as if I don’t know anything about it, and thus study it deeply.”

Instead of thinking that I’m competent and “know everything” about a business, I start as being incompetent.

This thought-process helps me be mindful of the risks that a business may possess – a business where accidents may be waiting to happen.

Keep it simple
Charlie Munger says, “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.”

So here’s what you can do to draw your own circle of incompetence…

  1. Take a list of companies – say the BSE-200 index.
  2. Start with creating your circle of incompetence by junking some businesses that you obviously don’t understand. Like for me, those are banking, pharma, oil & gas, commodities, and real estate.
  3. For rest of the businesses, pick up their latest annual reports, read them and then decide whether you are able to understand them or not.
  4. For a business you still don’t understand – what is the product or service, how does the company earn sales and profits, what are the broad opportunities and challenges, who are the competitors etc. – skip them as being part of your circle of incompetence.
  5. Don’t feel bad if your circle of incompetence is too big. Instead, feel happy that you won’t have to worry about all those businesses. 🙂
  6. For businesses you understand (simple businesses), add them to your circle of competence, and then use a basic excel model to do a deeper analysis.

The idea is to keep things simple.

Know the boundaries of your competence, and then look at things inside that circle.

Better still, know the boundaries of your incompetence, and then look at things outside that circle.

Basically, keep it simple, know the boundaries, and you will be fine.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Nishanth says:

    Vishal, out of curiosity…You have mentioned above that you don’t consider cyclical stocks to be in your circle of competence..yet in your StockTalk reports you have analyzed BHEL,EIL and Tata Steel ( Even considering that Tata Steel is the only purely cyclical company in the above 3). Capital goods is somewhat of a cyclical sector , is it not?

    Or am I wrong here?:)

  2. Nishanth, I stand to correct myself. When I wrote cyclicals above, I meant purely commodities (steel, cement etc.). As for BHEL and EIL, their business is cyclical “in nature” like most other businesses from most other sectors are – they do well when times are good and poorly when times are bad, but otherwise they are relatively easier businesses to understand.

    As for Tata Steel, well I analyzed it because when I started StockTalk, it was purely a “request-based” initiative and there were a lot of requests for this company. So I read it through and penned down my thoughts. That’s it! If you ask me now for a report on Tata Steel, I may not do that. 🙂

  3. Vishal,
    Sometimes I really wonder how you are able to pick topics and explain them in an extremely simple language which any novice like me can also understand and connect to. As always, great work….keep writing.

    Regards,
    Raj

  4. Rajaram S says:

    Thanks for sharing a good idea. This is my biggest area of weakness, I still cannot state my circle of competence, or incompetence confidently. Let me try the method you have suggested. I am grateful to you for offering your experiences to us generously.

    Regards,
    Rajaram

  5. “Knowing what not to do is often ignored but a vital question whose answer we must visit from time to time.”
    You have written a lucid article on this aspect and shown a way to actually go about doing it.
    Thank you, as always.
    Your point on letting go off assumptions that I know and instead always being in the mode of what else should I know is very apt.

  6. R.K.Chandrashekar says:

    Dear Vishal
    I have been for a while, thinking of how and which stocks to exit, to reduce the size of the folio. Now this post gave me a clue- get rid of stocks which are not in your circle of competence! Back then you invested in stocks and later try to built your competence around it!! Putting the cart before the horse. Your post is a real eye opener for anyone who wants to invest in stocks.

  7. Whatsup Prahalad says:

    Vishal ji:

    In an information driven world where the market regulator makes available information which maybe a decade back was available only to analyst ..
    I think competence can be easily acquired ..

    As Mr Sakaiya says in his book “Knowledge Value Revolution” In the future ..Knowledge will be available easily in the internet generation.. the question is to create value out of the available knowledge..

    But your statement still holds true.. For a company like Reliance with so much complexity it becomes difficult to really determine value out of the freely available information… Here again one more important concept is “simplify” it to a level where its down to a yes/No.
    —————————
    For Eg: This is with regards to General Motor’s Bankruptcy..
    When bankruptcy was announced stock plummeted .. and even the bonds fell. A 25US Dollar bond was available for 2US Dollar. This was a bond with Coupon rate 5%
    5% of 25 was: 1.25 USD was the interest payout every year.
    So the 2USD Bond was giving out 1.25USD as interest payment each year..

    The question was is the GM (Unsecured Bonds) of 25USD face value was a great Value buy at 2USD?
    1. I Tried to understand GM .. but GM the largest car maker in the world with 200 Billion dollar sales and production plants in every continent..almost 30 labels/brands was something very difficult to really grasp.. I tried to simplify it..
    2. I then searched for data on bankruptcy and bond value..
    2. Information available was a simple one sentence: “that in case of bankruptcy the Equity shareholders loose all their equity and Bond holders on an Avg get 90 cents to a dollar of bond..”
    3. 90cents to a dollar gave 25USD bond as actually worth 22.50 after bankruptcy..
    4. GM was under bankruptcy protection but not yet declared bankruptcy.. and GM bonds were paying interest every 6 months.

    – I bought 25USD GM bonds for USD 2..
    – Since the bankruptcy process itself took 9 months I got interest payment of 62 cents waiting for bankruptcy to be declared..
    – After bankruptcy I received new bonds of lower face value and received GM stock as well as Warrants that can be converted into shares..

    All in all .. I got 600% return for an investment period of 3yrs..
    ————————–
    Was GM bonds my circle of competency.. no
    but simple logical thinking that one gets 90cents to a dollar of bond face value in case of bankruptcy
    for majority of bankruptcies.. did the trick!! (simplify the process of decision making..)
    ————————–
    so Bankruptcy value of GM bonds was ideally “22.5” USD and it was available at “2” USD …deep discount is what made the decision simple..
    ————————–
    So I would add my 2 cents : Its not possible to understand every little detail.. try and simplify the decision process.. and then make the decision “Yes”/”No” keeping a margin of safety..
    Even Buffett and Munger or Indian stalwarts like Bakshi or Damani cannot decide on a Specific Intrinsic Value/number..

    They come out with a range say 20-30 and then if the stock/bond is available at 5-6 or in case of bankruptcy 1-2 you can invest.. provided a due diligence is done in determining the intrinsic value
    —————————

    =happy investing

  8. Transcripts of conference calls are also very helpful.I held a couple of castrol shares a few months back.In the conference call management said that lubricants market would see very low growth due to improving technology.The quarterly numbers also showed poor sales.This lead me do sell the stock (at a decent profit).The stocks still quoting at 30 p/e.

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  1. […] stick to Buffett’s philosophy of operating within my own circle of competence. I have been an oil-man in past. Hence I understand this sector better than any other […]

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