What is The Meaning of Circle of Competence? | RW Education Series

Chris Lee Susanto, Founder at Re-ThinkWealth.com

10 May 2019

Circle of competence is one of the key concepts that value investors apply to make money from the stock market.

Warren Buffett often talks about the circle of competence concept but not many understood it.

In this article, we will explain the meaning of circle of competence in value investing and how we can apply circle of competence to be a better investor.

1. What is the meaning of circle of competence?

Image Source: Business Insider

Circle of competence is simply the area where we can make a fairly accurate and confident decision on.

In a layman term, “circle of competence” is the area where “we really know our stuff.” Not the area where “we think we know but we actually do not know.”

Understanding accurately where our circle of competence lies — and staying inside of it — is the goal for value investors to make money over the long run.

2. How can we apply the concept of circle of competence to make money from the stock market?

“I’m no genius. I’m smart in spots—but I stay around those spots.” – Tom Watson Sr., Founder of IBM

In order to make money from the stock market, it is not just about researching and capitalizing on opportunities.

It is also about minimizing losses.

In order to minimize loss, we need to be a very rational human being. We need to be a very rational investor.

Applying the concept of the circle of competence helps us to stay grounded by staying away from areas where we have no circle of competence.

That means, by knowing and trying to think where our true circle of competence lies in, we will be able to know what we should not do. And knowing what we should not do helps us to potentially minimize our losses by not dabbling in the area we have no circle of competence in.

Application example of the concept of circle of competence:

If I understand how the telecommunications industry makes money but I do not understand how bio-pharmaceuticals company makes money, I should stay out of the biopharmaceutical industry and stay within the telecommunications industry.

What this actually means is that if we do not understand bio companies well enough to make a decision on it, even though for whatever reason, the share price looks attractive or our friends are buying it, we have to be disciplined enough not to touch it.

Now, this is the application of circle of competence.

It is not simply knowing what we know and knowing what we do not know. It is acting on it with rationality.

3. Can we develop and expand our circle of competence?

I believe yes we can.

By knowing what we have more circle of competence in and less circle of competence in, we are able to learn and expand our circle of competence over time.

Because after all, we all started out with 0 knowledge of anything in this world as a baby, and as we grow older and learn, we are able to expand our circle of competence naturally through learning new things — and going deeper on it.

For example, in the example earlier we talked about not understanding biopharmaceuticals company.

Can we learn more about biopharmaceuticals company? And in the hope that one day, it can be within our circle of competence? I would say yes. It is not going to be easy, but it is possible to develop and expand our circle of competence.

4. What Warren Buffett says about circle of competence?

“What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”

“There is nothing wrong with a ‘know nothing’ investor who realizes it. The problem is when you are a ‘know nothing’ investor but you think you know something.”

“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.”

5. In Summary

Understanding where our edge as an investor is important if we would like to be a great investor.

Charlie Munger has great advice for all of us that are linked to the concept of the circle of competence.

“You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.

If you want to be the best tennis player in the world, you may start out trying and soon find out that it’s hopeless—that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes the intelligence. But after a while, you’d gradually know all about the plumbing business in Bemidji and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence—which results partly from what they were born with and partly from what they slowly develop through work.”

Understanding the circle of competence is key for all value investors.

While yes, we can develop and expand our circle of competence, it is equally important to stay rational and be honest if whether we truly have the circle of competence in that particular industry or not.

​Because as Charlie Munger said from the above quote, to get ahead, we need to figure out what our aptitudes are.​ Which also means we need to figure out what is inside of our circle of competence and what is outside of it.

Remember what is more crucial is not the size of the circle of competence, it is whether we are clear on the boundary of it and important that we stay inside of it.

This way, we can make better decisions which will ultimately lead to better investment returns over the long run.

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The information provided is for general information purposes only and is not intended to be a personalized investment or financial advice.

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