Warren Buffett is one of the most successful investors in the world. He has a simple philosophy when it comes to investing: stay within your circle of competence. What does this mean?
Let's explore what the oracle of Omaha meant by this quote. This strategy can be applied to many areas of life, especially when it comes to investing.
This article will feature an explanation of what the circle of competence is and give some examples of how it can be applied. We will also explain why it is important to stay within your circle of competence and offer some tips on how to do so. Although you can increase the size of your circle of competence over time, it is important to start small and focus on what you know best.
What is meant by the circle of competence?
The circle of competence is a concept that was popularized by Warren Buffett. It refers to the idea that there are certain things that we know well and understands completely, and there are other things that we know nothing about.
Imagine a circle. The things that fall within the circle are the things that we know about and understand. These are the things that we feel confident in investing in or making decisions about.
They are subjects that we have studied and understood completely. Within the circle, you can get a good sense of the topics and can see the connections between them. The things that fall outside of the circle are the things that we don't know anything about.
We might have a general understanding of them, but we don't have the expertise to confidently make decisions about them. Since they are outside our circle, it can be difficult to see what is happening and how the different pieces fit together.
An analogy to visualize how the circle of competence works is if you grew up on a small island. On this island, some fruits can be achieved easily through labor as well as traps set by predators. The things on the island that are familiar to you would be considered part of your circle of competence. You know how to navigate around the island and thrive in this environment.
One day, on the horizon you see an old wooden ship. It's not clear as to what it is and its intentions. Is it a ship coming to give gifts or is it preparing for an attack?
You don't know because it's completely foreign to you and outside of your circle of competence. In this situation, it would be best to stay on the island and not venture out to sea. By swimming toward the ship, you could drown because you are not aware of the dangers that are lurking beneath the surface. Sure, you could make it to the ship and receive substantial rewards, but the journey to get there might be too risky.
Rather than abandoning your expertise on the island, it's best to stay within your compound and build on top of it to defend in case the shipments coming are a threat. If they are friendly, you can always build a bridge to expand your circle of competence. But it starts with creating an infrastructure of wisdom from what you already know.
Now, imagine that you are suddenly transported to a large continent. This continent has a variety of climates and terrains. The things on this continent would be considered outside of your circle of competence.
You wouldn't know how to navigate or find food and shelter in this new environment. Rather than expanding your circle of competence you have been completely overwhelmed by everything new and unfamiliar to you. In this situation, it would be best to find someone familiar with the continent who can help guide you.
This person would be considered an expert in their field and have a large circle of competence. By following their lead, you can learn about the continent and eventually expand your own circle of competence.
The takeaway from this story is that it's important to know your limitations. Just because there are opportunities to venture outside of your comfort zone, doesn't mean that you should. It's important to be aware of the risks involved and make sure that you are prepared before taking any leap into the unknown.
What does this have to do with investing?
Warren Buffett has said that his rule for investing is to "only invest in things that you understand." This is because he doesn't want to take on any unnecessary risks. He would rather stay within his circle of competence and focus on the things that he knows best.
For example, Buffett has said that he wouldn't invest in technology companies because he doesn't understand how they work. He also doesn't invest in commodities such as gold because his circle of competence won't allow him to. Warren Buffett prefers to invest in businesses that produce goods and services rather than speculate on the future price of a product.
Now, does that mean others can't be successful in technology and commodities? Of course not. Those that have been involved in these industries and the factors that contribute to their success are within their circle of competence. They have the knowledge and experience to make informed decisions about these investments.
The circle of competence is a tool that Buffett uses to limit his investment options. By staying within his circle of competence, Buffett has been able to avoid making any bad investment decisions.
This is why it's important for investors to only invest in things that they understand. If you don't understand something, it's best to stay away from it. If you must venture out, look for quality guidance and expand your circle of competence rather than being overwhelmed and blindsided by the unknown.
It's great to learn more broad topics as it can help you to better understand the world around you. But, when it comes to investing, specializing in a specific area will help you to make more informed and successful decisions.
Circle of competence examples
There are many pathways to success as an investor. With so many asset classes, industries, and companies to choose from, it can be difficult to know where to start. This is where the concept of the circle of competence comes in.
For example, if your family is from a long bloodline of doctors, you may have a greater understanding of the healthcare industry. Therefore, you would be said to have a "circle of competence" in healthcare.
You can also develop a circle of competence through experience and education. For example, if you have worked in the retail industry for many years, you would likely have a better understanding of how retail companies operate.
The same can be said for someone who has a degree in accounting or finance. The circle of competence can also be expanded by your social circle. An example of this would be if all of your friends work at a company except you, you can still receive valuable information about that company by talking to your friends.
If you are disconnected from a social circle that can help increase your circle of competence, you can still learn about it on your own. Just make sure that you truly are competent in an area of the markets before investing.
A good way to do this is by reading books, researching companies, and speaking with experts in the field.
Warren Buffett understands businesses. Production costs, competitive advantages, reading financial statements, etc. This is his circle of competence. And because he understands businesses so well, he has been able to find great investments in companies like Coca-Cola, Walmart, and eventually Apple.
It took a while for Buffett to take a bite into the tech company (Apple) because he wanted to make sure he understood the business before investing. Take these examples and see how you can relate to your own circle of competence.
If you're a mechanic and know the ins and outs of cars, you can find vintage cars and invest in them. You can also expand your circle of competence by learning about the businesses that manufacture your beloved vehicles. From there, you can learn how to read the company's balance sheet.
Eventually, you might be competent enough to invest in the company's stock. As you can see, starting with your circle of competence is important, but it can always be expanded.
Why you should stay in your circle of competence
It's important to stay within your circle of competence because this is the only way to guarantee that you'll make decisions based on knowledge rather than speculation. We can often become bored with what we know and try to explore too far past our comfort levels.
This is a dangerous game to play when it comes to investing. If you don't have intimate knowledge about a company or industry, you're likely to make poor investment decisions. Often people will ask, "Are stocks a good investment?"
The answer to this question is, "It depends." It all comes back to your circle of competence.
If you're knowledgeable about a company or industry and have done your research, then stocks may be a good investment. However, if you don't know much about the subject, you're likely to lose money.
This is because it's difficult to intelligently base your decision on sound information. If you aren't competent but are passionate about stocks, feel free to expand your knowledge base by reading more articles published on this website. By doing so, you will become more competent and increase your chances of success when it comes to stock market investing.
The bottom line is that you should always stay within your circle of competence when making investment decisions. However, you can still expand upon your circle by educating yourself on new companies and industries. Doing this will help you make better investment decisions and improve your overall financial situation.
Buffet meant that you should at least be competent before considering an investment. And competence can be expanded through study and effort. But we all have limited time, so it's best to focus on the areas where we're already competent. By focusing on our strengths, we can find the best investments and achieve financial success.
Warren Buffett has used this philosophy to create a successful investing career. He has accumulated a vast amount of wealth in both monetary terms and wisdom. By sticking to what he knows best, he has been able to achieve great things.
Warren Buffet reads a book a day to increase his competence, and expand his circle of competence and you can apply the same approach.