Lesson #7: How to Create Your Circle of Competence

Value Investing Masterclass - Safal Niveshak“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’.

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

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

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.

Ask your doctor friend who invested in dot-com 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 step outside the circle. Spend some time studying industries outside your circle before crossing the boundaries.

The idea behind the Circle of Competence filter is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing.

Not just investing, even otherwise in life, people who venture outside what they know have found themselves in dire straits.

So how do you find out what’s your circle of competence?

People who have attended my Investing Workshops know that my answer to this question is – Embrace constraints, and know your circle of “incompetence”.

Now, when Munger thinks of his own Circle of Competence, he starts by inverting.

Like to understand how to be happy in life, Munger will study how to make life miserable, to understand how a business becomes big and strong, he first studies how businesses decline and die.

Know Your Circle of Incompetence

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 & 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 would companies benefit from new drug research.

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.

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

Anyways, one of the questions that I get a lot from readers of Safal Niveshak is – “How can a small investor create his Circle of Competence?”

Here’s what I do 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.

So here’s what you can do to draw your own Circle of Incompetence…

  • Take a list of companies – say the BSE-200 index.
  • 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 (this, I don’t trust!).
  • 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.
  • 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.
  • 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.
  • For businesses you understand (simple businesses), add them to your Circle of Competence, and then do deeper analyses on them.

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

Again, it’s not important how big your Circle of Competence is. What’s critical is to know where the edges are.

Now you may ask – “But how do I expand those edges so that I can expand my circle of competence?”

Developing or expanding a Circle of Competence is hard. But there’s still a way. That way is to read a lot and learn a lot.

Munger loves to talk about 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.

So read a lot. That’s the only way you can expand your Circle of Competence.

The simple takeaway here is clear. If you want to improve your odds of success in life and business then define the perimeter of your circle of competence, and operate inside.

Over time, work to expand that circle but never fool yourself about where it stands today, and never be afraid to say, “I don’t know.”

Here is a bonus for you. A video I had created for students of my Mastermind Value Investing Course.

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