Imagine this: You’re at a carnival, stepping up to a game of darts. You’ve got a clear strategy, aiming only at targets well within your reach. This is much like the investing strategy of Circle of Competence, a concept that has guided Warren Buffett and Charlie Munger to nearly 20% annualized returns since the mid-1960s. It’s a straightforward yet powerful approach: focus on what you know best, and the results can be extraordinary. Let’s dive into the Circle of Competence, its origins, and its application in the world of investing.
Baseball and Business: The Birth of the Circle of Competence
Back in 1968, Ted Williams, a legend in Major League Baseball, penned ‘The Science of Hitting‘. In this book, he presented a striking image: himself with a bat, the strike zone divided into 77 squares.
Williams had a simple yet profound philosophy: swing only at pitches in your sweet spot to maximize your batting average.
… the single most important thing for a hitter was “to get a good ball to hit”.
Ted Williams
This approach, focusing on one’s strengths, is a cornerstone of the Circle of Competence.
Warren Buffett, in the documentary ‘Becoming Warren Buffett’, draws a parallel between this baseball strategy and investing.
Warren Buffett says,
I can look at a thousand different companies, and I don’t have to be right on every one of them or even 50 of them.
So, I can pick the ball I want to hit.
And how do you apply the Circle of Competence investing strategy?
…the trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot.
And if people are yelling ‘Swing, you bum,’ ignore them.
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Warren Buffett’s Take: Simplifying the Circle of Competence
Warren Buffett, often hailed as the Oracle of Omaha, is credited with popularizing the term ‘Circle of Competence’.
As explained in my previous article on what is Circle of Competence:
It is a concept that identifies the range of subjects or skills where an individual truly excels. It’s about distinguishing what you genuinely know from what you think you know, emphasizing the importance of recognizing your knowledge boundaries to guide effective decision-making.
Simply put, a Circle of Competence means understanding where your expertise lies and sticking to it.
In his 1996 shareholder letter, Buffett emphasized the importance of this concept:
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.
So, we know the Circle of Competence is critical. But how do you find your Circle of Competence? You need to do 4 things:
- Embrace brutal honesty about your strengths and weaknesses.
- Dive into the Competence Venn: passions, talents, and profitable skills.
- Sort these into ‘What You Know’ and ‘What You Don’t Know’ zones.
- Don’t forget #1.
Buffett’s take on this is straightforward yet profound:
The size of that circle is not very important; knowing its boundaries, however, is vital.
If you have doubts about what is or is not in your Circle of Competence, it usually isn’t.
Charlie Munger’s Wisdom: Decoding the Circle of Competence
Charlie Munger, Buffett’s long-time partner, simplifies this concept further:
We have three boxes: ‘In,’ ‘Out,’ and ‘Too hard.’ You don’t have to be a jack-of-all-trades. At the Olympics, if you ace the 100 meters, you’re not expected to throw the shotput.
We can make sense of the concept of the Circle of Competence by understanding the three zones of the Circle of Competence:
- Understanding what’s in the ‘In’ box, also, called the ‘What You Know’ zone;
- Understanding what’s ‘Out’ or ‘Too Hard’ is also, called the ‘What You Know You Don’t Know’ zone; and
- Staying away from the ‘What You Think You Know’ zone also called, the Danger Zone!
You should know the boundaries of your Circle of Competence and not fall victim to the Dunning-Kruger Effect, making consequential decisions about things you don’t know.
Munger’s advice is to play to your strengths:
If you’re five foot one, you don’t want to play basketball against some guy who’s eight foot three. It’s just too hard.
You need to understand where your aptitudes are and play that game to win.
If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.
Charlie Munger
Investing with Precision: Applying the Circle of Competence
For investors, the Circle of Competence is crucial. Investment decisions are consequential, often irreversible. As such, it becomes very important to understand which stock to buy and which one to sit out.
Buffett explains this in ‘Becoming Warren Buffett’:
There’s a temptation for people to act far too frequently in stocks simply because they’re so liquid. Over the years, you develop a lot of filters, and I do know what I call my circle of competence. So, I stay within that circle, and I don’t worry about things that are outside that circle. Defining what your game is, where you’re going to have an edge, is enormously important.
To identify promising investments within your Circle of Competence, ask yourself:
- What activities captivate you, both professionally and recreationally?
- What are your standout skills?
- How do you earn or spend your money?
This is called the Competence Venn which will help you find and align your Circle of Competence with your hobbies, passion, and personality. The intersection here is your Circle of Competence, your gold mine of expertise. The more a theme recurs, the more it speaks to your innate understanding.
This is how you value good investments using your Circle of Competence.
Mohnish Pabrai (my article on the lessons from Monhnish Pabrai), echoing Buffett’s philosophy, emphasizes the importance of staying within one’s Circle of Competence. When Pabrai analyzes a company, he starts by asking, “Is this something I truly understand?” He pushes himself to consider whether he’s at the center of his circle of competence, approaching its edge, or outside it.
The worst thing an investor can do is buy something which is outside their Circle of Competence, which they don’t understand.
Knowing you don’t know something is nearly as valuable as knowing it. The worst situation is thinking you know something when you don’t.
Ray Dalio
Berkshire Hathaway’s Journey: A Circle of Competence Case Study
Warren Buffett’s foray into Berkshire Hathaway is a classic tale of stepping outside one’s Circle of Competence, a venture that even the savviest investors might stumble upon.
It all began in 1962, with Buffett eyeing Berkshire Hathaway, a textile company that seemed undervalued, a hidden gem in the rough. Buffett bought the stock with the idea that as Berkshire closed textile mills and freed capital, there would be a tender offer at some point and they could sell the stock for a profit. However, the textile industry’s decline was a storm cloud on the horizon that Buffett hadn’t quite anticipated.
Fast forward to 1964, and the plot thickens. Berkshire’s president, Mr. Stanton, verbally offers to buy back Buffett’s shares at a fair price. Buffett nods in agreement, but when the written offer arrives, it’s a few cents short. This slight undercutting ignites a spark in Buffett, leading him to a decision driven more by emotion than his renowned analytical prowess. In a twist of fate, he buys more shares, not for profit, but to take control and oust Stanton.
This move, however, lands Buffett as the captain of a sinking textile ship. Despite efforts to keep it afloat, the industry’s decline was inevitable. By 1967, Buffett pivoted Berkshire towards insurance and other investments, marking a new chapter.
Warren Buffett has admitted that Berkshire Hathaway was the “dumbest stock I ever bought”. It wasn’t just about acquiring a failing company; it was a detour from his Circle of Competence, a decision marred by emotion rather than logic. Buffett estimates this misstep cost him a whopping $200 billion in opportunity cost.
In Buffett’s misadventure, we find a potent reminder of the power of rational thought in the world of investing and staying true to your Circle of Competence.
Mrs. B’s Tale: A Masterclass in Sticking to Your Circle of Competence
Let’s turn the pages back to Nebraska Furniture Mart’s story, founded by the legendary Rose Blumkin, affectionately known as Mrs. B. Warren Buffett, the investment maestro himself, was so impressed by her that he struck a deal based purely on a handshake in 1983.
Picture this: Mrs. B, at the sprightly age of 89, hands over 80% of her empire to Buffett, not through complex audits, but on mutual respect and a shared understanding of business value.
Fast forward a bit, and we find Mrs. B, at 95, not ready to hang up her boots. Unhappy with retirement, she starts “Mrs. B Clearance and Factory Outlet” right across from her old stomping ground. Buffett, recognizing her relentless spirit, eventually merges this new venture with Nebraska Furniture Mart.
Buffett has said about Mrs. B:
Put her up against the top graduates of the top business schools or chief executives of the Fortune 500 and, assuming an even start with the same resources, she’d run rings around them.
Why? Because she played to her strengths, staying snugly within her Circle of Competence.
At a later date, in one of the lectures, Warren Buffett explained the Circle of Competence using Mrs. B’s example:
Mrs. B is that way. I couldn’t have given her $200 million worth of Berkshire Hathaway stock when I bought the business because she doesn’t understand stock. She understands cash. She understands furniture. She understands real estate.
She doesn’t understand stocks, so she doesn’t have anything to do with them. If you deal with Mrs. B in what I would call her circle of competence… She is going to buy 5,000 end tables this afternoon (if the price is right). She is going to buy 20 different carpets in odd lots, and everything else like that [snaps fingers] because she understands carpet.
She wouldn’t buy 100 shares of General Motors if it was at 50 cents a share.
Mrs. B, much like Buffett, is a testament to the might of sticking to your Circle of Competence. It’s a lesson many CEOs and managers often overlook – the art of knowing what you know best and playing that game to win.
Embracing the Circle of Competence – Buffett & Munger’s Legacy
Defining your circle of competence is the most important aspect of investing. Tom Watson senior who started IBM said ‘I’m no genius, but I’m smart in spots and I stay around those spots’. That is the key.
Warren Buffett
In the investment arena, the Circle of Competence isn’t just a strategy; it’s your secret weapon. Buffett and Munger’s journey teaches us a simple truth: success lies in playing where you excel. Remember, in the vast game of investments, it’s not about covering all bases but acing your pitch.
Find your spot, own it, and let the magic happen.
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👉🏽 What is Circle of Competence and why is it important to recognize your circle?
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