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
That opening quote from Warren Buffett, written in his 1996 letter to Berkshire Hathaway shareholders, crystallized the concept of the circle of competence. We need to understand this concept if we are to be successful in our business and financial lives. What is it, how does it affect us, and how can we use it to further our lives?
The circle of competence concept certainly didn’t begin on that day in 1996. It can be seen in the writings of Andrew Carnegie’s autobiography:
My advice to young men would be not only to concentrate their whole time and attention on the one business in life in which they engage, but to put every dollar of their capital into it
A circle of competence is an area where you have an edge over the average person due to experience or education.
Here’s the definition from the Farnham Street blog:
Circle of Competence is simple: Each of us, through experience or study, has built up useful knowledge in certain areas of the world. Some areas are understood by most of us, while some areas require a lot more specialty to evaluate.
Now that we understand what the concept of the circle of competence is, how does it affect us?
Let’s hear from Warren Buffett’s business partner Charlie Munger
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.
The problem is that there is a big difference between what you think you know and what you know.
It is a trap that many people fall into. They think they know more than they do. In fact, many believe they have special insight into the future and, in turn, the market’s ups and downs. No one is prescient, it’s one reason why the typical investor often does so much worse than the market.
As I wrote about recently in 3 Things CrossFit has Helped Me Understand About Planning and Investing, ego can impede our improvement. Overconfidence in our own abilities can lead us to a big mistake. To quote Buffett again
You only have to do a very few things right in your life. So long as you don’t do too many things wrong.
Watch the downside of your decisions carefully. Make sure that if the worst-case scenario happens, you survive to play another round.
We know what the circle of competence is, and we see how venturing outside of it can affect us. How can understanding the circle of competence makes us better business owners and increase our financial happiness
If you’re an engineer, a doctor, a business owner, or an executive, you can improve your odds of success in life if you operate inside your circle.
3 major advantages of operating within your circle of competence.
- Knowledge gives you an edge: Nobody knows everything about everything. If you do focus on where you have an edge, it will often make you most profitable. Whether a physician, business owner, or an executive, you will likely increase income if you hire others for their circles of competence.
- You avoid mistakes: Charlie Munger said, “If you make fewer mistakes, your investment performance will be better.”
The difference between those who “make it” to their goals and those who don’t are the people who “make it” were consistent with their plan. They didn’t step on any land mines along the way.
There will always be setbacks in our business and there will always be downturns in our investments. If you can avoid the ones that leave you out of business or bankrupt, you are already further along the road to success than many others.
3. Narrow down options: 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 Decatur, that is probably doable by a good amount of you.
It takes a will. It takes intelligence. But after a while, you’d gradually know all about the plumbing business in Decatur and master the art.
That is an attainable objective, given enough discipline. People who couldn’t win a chess tournament or stand in center court in a tennis match can rise up by developing a circle of competence. Which results partly from what they were born with and partly from what they slowly develop through work.
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 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.” Always seek out help when you need it.