I’m no genius. I’m smart in spots – but I stay around these spots.Tom Watson Snr, Founder of IBM
Followers of Warren Buffett, myself included, would be familiar with the concept of “Circle of Competence”. They key to his philosophy is to encourage investors to stick to what they know best, evident from his Shareholder’s Letter.
What an investor needs is the ability to correctly evaluate selected businesses. Note the word “selected”: You don’t have to be an expert at 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 concept is simple. To invest successfully, one need not bother themselves with technical, such as beta, capital asset pricing models, modern portfolio theory or option pricing. As an investor, one should simply purchase a company that we understand at a reasonable price. Hence, what many investors should know is how to value a business and market psychology.
Last year, I strayed from this theory, buying Vard (then called STX OSV) and sold off my stake at a 30% loss. I had no one to blame but myself for trying to buy a business that I was completely clueless of. When news of the company having delays in the Brazilian market resulting in profit guidances, I did not know how to react especially with the stock price in free fall. That said, everyone makes mistakes, even Berkshire. In 1960s, they too wandered off from their circle by purchasing departmental stores. Also, Dexter Shoes is another example of failing to stick with their circle of competence resulting in Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) getting badly burnt.
It is important to stick within our circle because it gives us an extra edge over others. With that additional information of the business, it allows us to make better, more informed decisions and reduces the mistakes that we would commit. Outside of this circle, we are complete amateurs. In times of uncertainty, it would result in us panicking like the other 99% of the market, selling the stock before analysing the facts laid out before us.
Furthermore, we must never confuse familiarity with competence. Someone who may constantly be flying on the airplane does not mean that he is competent enough to be investing into the airline industry. Whilst many of us may use Facebook, YouTube or Twitter every day, this does not mean that we are able to understand how social media should be successfully managed.
What separate what we do know and what we think we know is a very fine line. It is crucial for us to define our circle’s boundaries, enabling us to improve our odds of success in stock pickings and actually in almost all other aspects of our life. This circle can be widened, however, it is not something achievable overnight and requires constant reading and talking to people whose competence lies in such other areas.