Circleof Competenceis a term used by many value investors.WarrenBuffet, a successfulinvestor, wrote in his 1996 letter to Berkshire Hathaway shareholders that youdo not have to be an expert on every company or even many. You are onlyrequired to understand a few companies that are within your circle ofcompetence. Just investing in companies you understand and feel comfortablewith can create significant wealth for you in the stock market or any otherinvestment. I mean by that, it's better to invest in companies that you haveunderstanding rather than gambling your way to invest in companies that youdon't understand.
This applies not only in investing in stocks but also in otherinvestments such as real estate and other assets. If you don't understand howthe businesses operate in a company or the investment, it's better to stay awayfrom it since you might actually lose money when investing in them.Understanding your circle of competence in investing helps you avoid makinginvesting mistakes, it helps identify opportunities that you have understandingand confidence in. So before you start investing in a stock, it is the best youreally understand the companies you are going to invest in.In this article, I'm going to explain what circle of competencemeans and how you can apply it to be a better value investor.
Defining Circle of Competence
Many value investors, such as Warren Buffetthimself, widely used the concept of a circle of competence. It is a concept inwhich investors focus on only operating and investing in areas they fullyunderstand well and have confidence in. It is a simple term to understand, andI believe everybody has their own circle of competence.
Each of us goes through experience or study, which eventuallybuilt up useful information on certain areas of the world. Some areas might beunderstood by many, while some aspect areas might require further knowledge tounderstand it fully. To illustrate this, those who have a basic understandingof the economics of brick and mortar retailers know how the business operates.They have to rent or buy a space, spend money to decorate the place, and hireemployees to serve the customers, clean and manage the store.
After that, it's a matter if the business can generate enoughtraffic and make sure that the stores can sell its merchandise after alloperating expenses have been paid. Through the type of business, retailers needto face; they all have to follow the same economic formula. This gives us thebasic knowledge of the business model. With some understanding of accountingand further study, an investor can evaluate and invest in these brick andmortar retailers, whether it is a good investment. It is pretty much thesubject area that matches your skills and expertise.
How Warren Buffett Apply This Term Himself
To Warren, the circle of competence is to understand specificindustry and business that allows him to predict, with a certain degree ofaccuracy, how the competition will turn out and translate into results a fewyears ahead. Warren Buffett limits himself from investing in companies that hedoes not have full understanding or expertise and only concentrating on areashe has the most significant familiarity.
He mentions what counts for most people in investing is not byhow much they know, but rather how practical they can measure what they do notunderstand. What he meant by this is that it is not critical to know a bitabout everything, but to know a great deal about a specific topic. Mostimportantly, it is essential to know your boundaries when investing, even whenothers are doing very well with their investment.
Investing in onlycompanies within his circle of competence made Warren Buffett invest inbusinesses that he only has a full understanding and has high conviction in.This resulted in him not only become a successful investor but wealthy as well.For example, before the dot com bubble, Warren was criticized by many for notentering the technology stocks. Warren was not able to find value in thesecompanies and had not much understanding of how the businesses even operate. Hesimply stays away from investing in these companies even when others make asignificant sum gain in their investment.
Envyandjealousycan get you in trouble since you see othersdoing well. This can result in us stepping out of our circle of competence justto match how others were making money. However, Warren sticks with hisinvesting principle and stays out from investing in tech companies before thebubble burst. Moreover, the result was excellent. When everyone was losingmoney during the dot com bubble burst, Warren's portfolio was doing fine.
WarrenBuffettwas so strictwith only investing within his circle of competence that he would not eveninvest in his close friend's company, Microsoft Corporation (Ticker: MSFT),that was found by Bill Gates. You guys probably know Bill Gates, who is one ofthe wealthiest people in the world. He had invented software that everyone isusing. Without him, I wouldn't be able to use a computer to write this article.
However, even whenBill Gates tries to persuade Warren to invest in his company, he mentions howhis products can benefit him. He told Bill to stick with what he knows, andWarren would stick to what understands, such as chewing gum and beveragescompanies within his circle of competence. For Warren to stay inside the circleof competence, he was able to obtain advantages for only investing in the areahe understood the most and gained good investment results.
Howto Apply a Circle of Competence to Make Money in Investing?
For an investor to make money in the stock market,it is not just about researching and monetizing opportunities. You are requiredto minimize your losses. You only want to invest in stocks that you understandhow the business operates and generate profit. If you don't understand how thebusinesses work, it's better to avoid it since it's something outside yourcompetence circle.
For instance, I don't have an understanding in how Alphabet Inc.(Ticker: GOOG) earns their income. All I know their business provides greatsearch engine service for people to use but have little understanding of howthey actually profit from the business. Because of this reason, I stay awayfrom investing in this company since I have no understanding and confidence inhow the business operates.
Applying this concept makes me as an investor to stay away fromcompanies that I am unfamiliar with. It would probably make me encounter somelosses if I blindly invest in one. Rule to remember, only invest in companiesor assets to understand how the business operates and generate income.
To give you readers another idea,my dad is an excellent example of a person who only invests inthings within his circle of competence. He wouldn't understand if someone gave him amillion-dollar worth of Apple shares because he does not even understand how astock operates. The only thing he understands is cash, fixed incomecertificates of deposits (CDs), Real Estate, and how to run a fan manufacturingcompany. Since he doesn't understand anything about stocks, my dad doesn't evendare to touch it as an investment or have anything to do with them.
I tried many times persuading him to invest some of his savingsin stocks; however, he always declines my advice. So if I want to deal with mydad, I would only approach him with opportunities such as land prices or theraw materials for his fan manufacturing business. He would understand the valueof these things since he has familiarity in this field. If you offer him landnear his factory right now for sale under the market value (in a snap of afinger), he would probably buy it from you because he understands the value ofthe real estate and lands around that area. It did not hurt my dad for notunderstanding how the stock market works.
Since he avoids investing in things he does not understand madehim a better investor. He avoids losses that can be lost in the stock marketand invest in things he has confidence in and, most importantly, understood.For instance, he understands how fixed-income CDs work in Indonesia. Realizinghow the property market in Indonesia is already overpriced, he manages to stayaway from investing further in real estate and have his spare cash invested infixed income CDs that generate high-interest rates.
I am amazed by my dad's circle of competence in investing. Imyself trying to challenge his investing strategy by investing my monthlysavings in Indonesia Blue Chips stocks by applying value investing havereturned significantly lower return performance compared to investing infixed-income CDs that generate a high yield. Even my brother, who is a realestate investor, lost to my dad. My older brother bought rental propertyapartments thinking that his investment would return a higher capital gain thanmy dad's strong belief in Indonesia's fixed income CDs yield rate. My brother'sreal estate investment lost when comparing its current market value to my dad'sinvesting performance in the fixed-rate CDs account.
My dad had already warned my brother and me that the current realestate value in Indonesia is already overpriced since the year 2015 and wouldnot increase as much as compared to have money invested in a fixed rate CDaccount. Because of his circle of competence in investing, my dad was able tomake more money just by having his money invested in the fixed-rate CD account.He is currently making more than 8% gross from the yield the fixed income CDsrate accounts provide. It is incredible how he was able tocompoundhis wealthby knowingwhen to invest and wait patiently for the perfect time to invest.
My dad, however, didnot have his cash invested in fixed income CDs all the time. Before, heinvested in a land (our current factory) in the year 2009; he had been waitingpatiently and analyzing the property market since 2007. He had his moneyinvested in fixed income CDs the majority of the time, and having thesefinancial instruments pay high yield for the investment principle. Beforepurchasing the factory, my dad (currently owns now), he waited patiently forthe right moment to enter the real estate investment. He told me he hadrealized the land, and the factory was at a bargain price when he learned thatmany shophouses had already increased by50%invalue from its original price.
He mentioned how a single shophouse is worth that much while ahuge land and factory be worth lesser than that. In 2009, he immediatelypurchased the land and the factory even when the seller had decided to increasethe price by10%from the original listing price in 2007. Heknows that the real value of the land and factory worth more than the price mydad is paying for. His investment in the real estate had inspired me since hewent in at the right time and getting an excellent value for the price he paidfor.
His investment in the land and factory nearlytenfold (1000%)comparingthe real estate market value now (July 2019) to the price he purchased in theyear 2009. If my dad had not purchased the land and factory in the year 2009,our whole family would have missed theproperty boom.We would probably have to purchase the land and the factory at a price way morethan the price he purchases.
Not only having theright timing in investing, given my dad's significant return, was he also ableto utilize the factory to manufacture the electric fans in higher capacity.Since his business was still growing, he needed land and factory that have alarge space. As you can see, my dad's understanding of real estate in Indonesiaand how to capitalize on the fixed income CDs gave him the advantage to investsuccessfully. These investments are within his circle of competence and gavehim the ability to enter the investment at the right time.
So remember, you donot have to master everything to become a successful investor. A person likesmy dad, who has no investing knowledge in the stock market, just stays awayfrom investing in things he does not understand; instead, he invests in things heunderstands, such as the real estate industry and into his manufacturingcompany. Similar toWarrenBuffet, who sticks to hisinvestment principle, the circle of competence has made my dad wealthy and agreat real estate investor.
Expanding Our Circle of Competence
I believe that expanding our circle of competence ininvesting gives us a broader opportunity to choose and see which one we aremost comfortable with. After all, no one is born with an investment circle ofcompetence. So how do we actually build one and expand it? Knowing your circleof competence in investing gives you the ability to understand a comfortablebusiness.
Once you become competent at one or two investments that cansimply generate great investment return, why should you bother trying toexpanding all your other circles of competence? The two reasons I'm going togive are opportunity cost and frequency of a good investment. It isbecause they are eventually connected to another. While you had already on yourcurrent spot, you will always see another opportunity that you can grab, so youcan expand your ability and chances.
Opportunity Cost
Let's say you already mastered analyzing particular types ofcompanies. If that is all you choose to do, you are bound to lose theopportunity and forego potential high return investment. I know it's crucial toonly invest in things you fully understand and comfortable with. But on theother hand, if you had a broader circle of competence, you might have to lookin other places as an investment opportunity.
As I continue to expand my investing experience and knowledge, Ilearned the importance of quality, both in businesses and their management, andit makes me became more willing to pay a stock at a higher price for thequality of the company. From my investing mistakes, such as purchasing a cheapstock like Game Stop Inc. (Ticker: GME), I now understand why it is cheap. I hadlost money in that investment since I was stuck in finding companies that areundervalued rather than finding quality companies that have longer businessprospects ahead.
This results in me wanting to find excellent quality dividendstock companies that might be trading at a fair price rather than finding poorquality high paying dividend yield companies that are trading at a discount.WarrenBuffetthimself claimsthat his worst investment was purchasing Berkshire Hathaway at a low price;however, knowing it was in a deteriorating business. From this experience, hechanged his investment philosophy. He mentions: "It is far better to buy awonderful company at a fair price than a fair company at a wonderful price."
Frequency of a Good Investment
WarrenBuffetthas alsodecided to expand his circle of competence in his investing practice. He usedto avoid tech companies, but he eventually changed and expanded his circle ofcompetence. Apple Inc. is one of the largest tech companies that designmanufacturers and market gadgets, computer and software is the most significantposition (23.77%weighted) in BerkshireHathaway's current portfolio (as of July 2019).
If Warren has expanded his circle of competence earlier in hisinvesting career, he could have bought Apple Inc. stocks at a lower price whenthe great recession of 2008 occurred. He could have made massive returns if hehad invested in Apple Inc. stock during that opportunistic time. This exampleshows that by not expanding your circle of competence, you can miss out onopportunities as Warren Buffett did with Apple Inc.
It is not simple,but it is possible to develop and grow your circle of competence. Regardless ofhow far you want to expand your circle of competence, the most important thingyou should do is to improve your thought process in general terms. By doing so,you will broaden your investment opportunity rather than wait in the sidelinesfor an opportunity to come in the narrow circle of competence.
I used to believe my dad's investing strategy is not strategicsince he put his money in fixed income CDs that I believe will not generatehigher returns than being invested in property or the stock market. However, Iwas able to broaden my circle of competence in investing since I learn thebenefit of having liquid cash in my investing career.
My dad has made me change my perspective on how to invest, andapplying his strategy can be beneficial for me. It made me realized that thereare many other ways to make money rather than sticking to one strategy you arecomfortable with. Having me learn how my dad invests his wealth expanded mycircle of competence.
He made me realizethe benefit of investing in other financial instruments besides the stockmarket. I was able to broaden my circle of competence in investing just by expandingmy knowledge and understanding of investing. It is good to stick to your circleof competence when investing, but it's never wrong to learn and expand yourknowledge and thought process. You might find opportunities that you might nothave discovered if you haven't expanded your circle of competence.
In Conclusion
Understanding the benefit to stick within yourcircle of competence is crucial if you want to become a great investor.Investors such asWarrenBuffetthave stuck withhis principle to generate the high return he made on his investment. Alwaysremember that even when others are making higher returnsthanyouin investing, it's essential that you should still stick within your circle ofcompetence. However, this does not mean you should not learn more and broadenyour circle of competence in investing.
You should always improve your thought process in investing sothat you can seek different opportunities out there. Sticking with what youknow well and comfortable with is crucial to prevent making investing mistakes,but increasing your knowledge beyond your circle of competence is also equallyimportant. By continually learning, you can increase your likelihood ofinvesting in things outside your circle of competence.
With new knowledge and understanding, you will eventuallybroaden your circle of competence. But always remember that the size of circleof competence is not as important as the boundary of it. If you don't feelcomfortable expanding your circle yet, it's best to stick inside the circle.It's better to make a better decision you are comfortable, which willultimately generate a higher return on your investment in the long run.
