One famous idea from Warren Buffett is the “circle of competence.” This concept, developed by Buffett and Charlie Munger, is one of the guiding principles behind their success in investing.
What is the Circle of Competence?
Each of us, through experience or study, has built up useful knowledge on certain areas of the world. Some areas are understood by most of us, while some areas require a lot more specialty to evaluate.
In a 1996 letter to Berkshire Hathaway shareholders, Buffett expanded on this concept.
How do you find your circle of competence?
- What are you passionate about? Make a list.
- Be honest. Eliminate industries that you don’t know about.
- Can you explain how a type of business makes money?
- Can you read an earnings report and come up with questions to ask?
- Can you isolate where a company stands amongst its competitors?
Distinguish between what you know and what you do not know. Learn from your mistakes.
Can you grow your circle of competence?
Short answer – Yes! Strengthening your circle of competence increases the quality of opportunities you can find.
An example of a famous value investor who stepped outside his comfort zone to invest in the auto industry is Mohnish Pabrai.
Pabrai discovered a fantastic investment opportunity, but he knew nothing about the auto industry, so instead, he passed it by. Later he was presented with the same opportunity, and this time, it tweaked his interest.
Instead of just buying the company and rolling the dice, he decided to learn as much about the auto industry as he could. He started studying the industry, reading books, periodicals, and industry reports, interviewing other investors in the space, and talking with insiders in the industry. Basically, he immersed himself in the industry to learn as much as possible before deciding to buy any company in the industry.
All the hard work and effort paid off because he was able to invest in Fiat Chrysler, and the company has proved to be an incredible investment for Pabrai.
Value investing is a never-ending journey of improvement and learning.
Find a passion and follow it.
“Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.” Charlie Munger
Peter Lynch, as the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than double the S&P 500 stock market index and making it the best-performing mutual fund in the world. His investment strategy is based on the simple principle that investors should invest in what they know. Avoid investing in companies or industries that they don’t understand.
- Only Buy What You Understand
- Always Do Your Homework
- Invest for the Long Run
Lastly – a quote from The Oracle of Omaha:
I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So, I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life.
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