Lesson #4: Know Your Circle of Competence, and Stay Well Within It

“What did you study in your college, Ravi?” I asked my friend.

“You know Vishal that I am a doctor! Why are you asking this unintelligent question?” Ravi looked at me with disgust. He was already disappointed seeing his stocks crash and savings wiped out. And now he had to face such questions from me.

“Oh okay, so you studied how medicines work on a human body, right? But what made you invest in a banking company then? Do you know how a bank works?”

“No Vishal! But are you telling me that a doctor can’t invest in a banking stock?”

“No, I am not saying that! What I am saying is that you must not invest in a banking stock if you don’t understand how a bank works.”

Ravi looked with confusion at me as I continued, “If you don’t know why rising interest rates suggest and how it is different from what rising blood pressure indicates, you have no right investing in a banking stock.”

You see, we generally do not know the answers to questions from subjects we have not studied in the past. And we are humble in accepting our ignorance on such subjects.

But things get different when it comes to investing in the stock markets. We have no qualms in going beyond the boundaries of what we know.

We have no doubts before treading beyond our ‘circle of competence’.

For most investors, investing outside their ‘circle of competence’ is what creates the maximum losses.

What’s your ‘circle of competence’?
In simple terms, your circle of competence with respect to investing defines your understanding about certain businesses.

The businesses that you understand fall within the circle, and the ones you don’t understand fall outside it.

As Warren Buffett, the world’s most successful investor ever, has said so often:

“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.”

This means that you as an investor need to restrict yourself to the businesses you know – businesses you can understand.

Understanding one’s circle of competence is a very necessary discipline in investing. Those who do not do this are left to suffer.

Draw your own circle as Buffett did his…
Buffett’s investing process involved creating three lists of companies – In, Out, and Too Hard.

Buffett’s List of Companies

This was his way of sticking to his circle of competence, however small it was.

As he said, “We have a ton of doubts on all kinds of things, and we just forget about those.”

Interesting, isn’t it?

But then…

The key idea behind the circle of competence is not its size – the number of businesses you can understand – but your awareness about its size – the number of businesses ‘you know’ you can understand.

This means that a simple and understandable business is one within your ‘circle of competence’.

It isn’t important how big that circle is. It is important how well you have defined its perimeter.

A business will be ‘within’ your circle of competence if you fully understand the underlying economics of it:

  • How it works?
  • What drives its growth?
  • What makes it profitable?
  • How does it stand against its competitors?
  • How does it manage its raw material costs?

You need to have the answers to such questions, and others like these to make sure that you understand the business. To invest in something you do not understand can have disastrous consequences.

Ask your doctor friend who invested in dotcom companies in 2000 without understating what the underlying businesses were.

Or ask your software engineer cousin who invested in real estate companies in late 2007, without understating the huge risks that lied on the balance sheets of these companies.

If you can’t find businesses within your circle of competence, don’t just expand the circle…or at least spend some time studying industries outside your circle before crossing the boundaries.

P.S.: Got here via a link from a friend, or a forwarded email? This is the 4th lesson of the 20-lesson free email course on the essential pillars of becoming a successful investor, Safal Niveshak-style. We talk about simple investing strategies that will work for you, and make you a smarter and successful investor.

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