Circle Of Competence: Investing In What You Know (1)

Investing can be daunting for the average person. However, hen you invest within your circle of competence, you are as good as the regular wall street investment guru.

When it comes to investing, your comfort zone is the best zone there is. You will always be better off investing in that small bar down the street where you and the guys meet for drinks, than investing in a state-of-the-art club in a country whose language you don’t even understand.

This is what Warren Buffett calls the ‘Circle Of Competence’. As far as the third richest man in the world is concerned, if you don't understand a business, don't buy it. The idea behind it is that investors must only focus on areas they are familiar with. In his 1996 Shareholder Letter, he explains that:

“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.”

The world of investing can be intimidating and might seem very complicated especially if you are not a stock market professional. For many, this is why they are hesitant to invest in the first place. However, a great way to beat the system is by staying within your area of expertise.

If we took a look at the patterns of our lives, we would realize that this is a theory we already follow consciously or unconsciously. It is how, even though there are many routes to your house, you typically stick to one – which is usually the most tested – unless an external force causes you to shift.

It is why we would ordinarily stick to specific restaurants and supermarkets while shopping even though there are hundreds available. It is also why you would not ordinarily get into a game duel without believing to a certain degree that you've got an edge.

You can only play within your own circle of competence and it is as simple as sticking to patterns that work.

In investing, the circle of competence is represented as the small circle within the larger realm of possibilities:

It is about sticking to what you understand and can analyze. For example, if you have worked in real estate for twenty years of your life, while companies within the industry might differ, you are safer investing in that industry as oppose venturing into e-commerce.

This is because you would have deep knowledge of the business; you would know about its seasons, its downtimes, and be able to adequately forecast the company’s future performance based on indicators.

Straying from this circle of competence is what leads investors to speculation; mistakes are most often made when you stray. It is however, important to note that the circle of competence can be widened, but it is typically over time at a very slow pace.

When it comes to investing in what you know, determining your circle of competence is only the first step. You still need to consider other factors like future prospects, its price, and so on. In our next post, we would look at some of the things you must know about a company before you invest.

Written by Lawretta Egba.