Circle Of Competence: The First Step In Picking Winners

It’s a beautiful Saturday afternoon and you’re having lunch with your family in a quaint restaurant. Suddenly, you feel a sharp pain in your stomach, a pain that you have never felt before. You decide that it needs immediate attention and rush to the nearest doctor.

You didn’t go to the nearest plumber or the tax accountant. You went to a doctor instead.

Why? Because only a doctor is competent enough to treat a health concern.

But, when it comes to investment, a lot of investors go ahead and buy stocks in industries they have no competency in, and I have been guilty of it in the past too. Driven by FOMO, people end up buying stocks they have no clue about.

This is where a lot of investors set themselves up for failure.

Circle Of Competence

All of us have knowledge of certain things but have no expertise whatsoever in many things. For example, the doctor above may know a great deal about the pharmaceutical and healthcare industry, but would he/she know enough about microchips to invest in NVIDIA?

Charlie Munger, in his iconic talk at USC Business School in 1994 says the following about the circle of competence:

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.

It doesn’t matter what the hottest stock out there is. All that matters is what you know about the company you’re investing in.

Moreover, it’s important to know the perimeter of your circle of competence because a lot of investment mistakes happen when one strays outside of this perimeter.

My Experience With Amazon

When I started my investing journey, Amazon was one of the first stocks I bought. As a frequent user of Amazon’s retail and entertainment services, I was confident in my understanding of its business.

But I ignored the impact of AWS (Amazon Web Services). It’s a significant contributor to Amazon’s cash flows and as of writing this post, I have no expert-level understanding of how AWS works. I have no answer to questions like:

  • Why would a client choose AWS over Microsoft’s Azure or Google Cloud Platform?
  • What would be the future of AWS in 10-15 years?
  • What could be the potential headwinds for AWS in the future?

This made me take a step back and re-evaluate my investment in Amazon. Because if I can’t confidently answer fundamental questions about a business, I will never be able to hold on to it during volatility.

How Does Circle Of Competence Reduce Risk?

When you play within your circle of competence, you will be better able to identify:

  • the moats of the companies,
  • the growth runway for the next decade,
  • and possible headwinds that the company in your investable universe might face.

You will also be able to read the annual reports and financial statements with considerable ease.

The chances of you making a mistake in stock picking are greatly reduced when you stay within your circle of competence.

As an added bonus, you save a lot of time and energy by ignoring the thousands of companies outside of your circle of competence.

How To Create Your Circle Of Competence?

Personally, I have created my circle of competence basis how much I understand businesses in an industry. Certain industries like FMCG, automobiles, ecommerce, hospitality, entertainment etc are easier to understand.

As a marketer and content creator, I also have a good understanding of tech companies in the media space like Meta Platforms (Facebook), Snap, Pinterest etc.

On the other hand, I avoid companies from industries such as banking and finance, core IT & software, oil & gas etc. I find it difficult to read the financial statements of banks, nor is it easy for a non-coder like me to figure out how certain tech companies work with their clients. I also avoid industries where government regulations decide the fate of the companies, like oil & gas.

So when you sit down to define your circle of competence, ask yourself the following:

  • Can I explain to a 4th grader how the company works?
  • Do I know what factors influence the decision-making of customers/clients of the company?
  • Do I understand how the company earns revenue, profits and cash flows?
  • Do I know the competitive dynamics of companies within the industry?

When you can answer the above questions with confidence, you can add the companies/industry to your circle of competence. But the process requires effort as you will need to read annual reports of the companies. It’s not an easy task but certainly a rewarding one.

Size Of The Circle

Also, it’s totally alright if your circle of competence is small. Warren Buffett has always invested in companies that are easier for him to understand, such as Coca-Cola, Wrigley’s, See’s Candies, Apple etc.

You don’t need hundreds of stocks in your portfolio anyway. All you need to know is where your circle of competence ends so that you stay within the game you are adept at playing.

If you want to expand your circle of competence, the only solution is to learn, learn, and learn.

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