A circle of competence is an imaginary representation of your field of expertise. In order to be a successful investor, you need to know what you know, and what you do not know. The circle represents the areas and industries in which you have insights.
What is the meaning of the circle of competence?
The meaning of the circle of competence is the areas in which you are an expert. The circle of competence represents your knowledge base and the industries and business areas in which you have more insights than other investors.
This concept is extremely important to understand, in order to be a successful investor. According to Warren Buffett:
“If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter” - Warren Buffett
How do you find your circle of competence?
In order to find your circle of competence, you need to be radically transparent with yourself, and determine exactly which areas you are an expert in. One of the ways to find your circle is to challenge your assumptions.
You can do this on your own, or with the help of an industry expert. Discussing specific details about a certain industry allows you to verify exactly what you know. In a way, you are backtesting your own knowledge, in order to confirm if you truly are able to accurately analyze businesses in that industry.
Finding your circle of competence requires extreme intellectual honesty. In order to determine exactly where is your edge of competency, and how far can you stretch your own knowledge.
What does Warren Buffett mean by a circle of competence?
Warren Buffett describes the circle of competence as the areas in which your experience, knowledge, and expertise are the highest. In turn, you are able to make better investment decisions that are related to these industries, due to the insights you possess.
Warren Buffett has been one of the largest advocates for the importance of knowing your circle of competence. According to him, if you know exactly which areas you are well versed in you avoid making investment mistakes.
His argument is that whenever an investor ventures outside of his circle, he is taking higher risks. Since there are other investors that are more knowledgeable about that particular area, and that are able to make better decisions.
How do you expand the circle of competence?
To expand your circle of competence you need to expand your current knowledge. This can be done by thoroughly studying a certain industry, or talking with experts within that industry.
You may also want to consider getting work experience in that area. As it can give you a much better impression of how that industry actually works.
In order to expand your circle of competence, you need to dedicate your time and energy to it. Becoming an expert in any topic takes time, and requires a significant amount of effort.
Why you should stay within your circle of competence?
Staying within your circle allows investors to avoid making naive investments mistakes. Even some of the most successful investors stay within their circle. The reason is that they know the advantages they have over other investors and market participants when they analyze businesses that they are familiar with.
Investing in industries that you do not know is a sure way to make investment mistakes. By avoiding investing outside of your circle, you are avoiding making bad judgments.
What is the edge of competency?
The edge of competency represents the boundaries of your circle of competence. It represents areas in which you are not so knowledgeable, and therefore you should avoid making any investments outside of your circle.
By sticking within your circle you avoid making investments that you have no insights on. It is crucial to know exactly what you are investing in.
Why knowing your edge of competency is essential?
Both Charlie Munger and Warren Buffett have outlined the importance of knowing your edge of competency. According to them, knowing your edge of competency is even more important than having a large circle of expertise.
This is because knowing exactly what areas you have an advantage in, allows you to avoid investing outside of your circle. This type of investment is usually riskier since you are not fully capable of assessing its risk-reward profile.
By sticking within your own circle you avoid one of the most common investing mistakes, which is investing outside of your circle.
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