Circle Of CompetenceGary Mishuris, CFA
Warren Buffett wrote in his 1996 letter to Berkshire Hathaway shareholders: “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. The size of that circle is not very important; knowing its boundaries, however, is vital.” He also said on a separate occasion: “What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.” How should you define your circle of competence and to what degree should you try to expand it over time?
Defining your circle of competence
What is inside your circle of competence? It is probably less than you think when you consider one of the most common behavioral biases, over-confidence. In response to my recent article describing a checklist that every investor should consider before investing, I received a comment to the effect of “This is a great list, but is it really realistic for a retail investor to be able to do all of this stuff?” My genuine response was along the lines of “Is it really realistic for an investor to not do this level of in-depth thinking about a prospective investment and still expect to do meaningfully better than the market?”
Those who are not able to devote considerable time developing an investment process and then applying it rigorously to make investments are better off not trying. As I explained in my article comparing the merits of active vs. passive investing, if you are one of the many for whom this level of time commitment is not realistic, and neither can you assess an active manager’s investment process, then your circle of competence might lead you to a passive approach.
Let’s say that you have built a rigorous process, have the right temperament and are able and willing to spend considerable time applying this process to assess individual investments. How should you define your circle of competence then? The answer is based on a combination of three things: behavioral comfort, inherent predictability and domain expertise.
Behavioral Comfort: Making a purchase is not the end, but to paraphrase Churchill just the end of the beginning. What remains are a myriad of potential future decisions: when to sell, how to incorporate many possible fundamental developments, when to make the investment a larger commitment, and so on. If you are viscerally uncomfortable with an investment then you are not likely to be at your best making these important future decisions and should consider not making the initial investment in the first place.
Inherent Predictability: Some businesses are more predictable than others. It’s easy to get excited by the latest technology or a new emerging business model, but more often than not almost nobody can foresee the future with any degree of confidence. It’s not a matter of domain expertise or experience, the future is murky. To give an extreme example – no matter how much you study the art of predicting the outcome of a fair coin toss you are just not going to get an edge.
Domain Expertise: If you are comfortable with the nature of an investment and it is not inherently unpredictable, what remains is building sufficient domain expertise to be able to have a reasonable chance of estimating the future. This is where time and effort are likely to pay off. Studying the history of the industry and the company, and performing rigorous economic and financial analyses can yield useful insights. Beware – domain expertise is necessary but not sufficient without the other two conditions holding true.
Expanding your circle of competence
Nobody is born with an investment circle of competence. So how do you build one and then expand it? And at what point should you stop trying to expand and remain inside your current boundaries?
Growing your circle of competence, like many things in investing, is a balance between deserved confidence and humility. All else being equal, simple investments and investment types are better than more complicated ones. Once you have become competent at one or two relatively simple investment types and justifiably feel confident in your ability to find profitable investments among this set, why bother trying to expand your circle of competence and master new, potentially more difficult, types of investments? There are two reasons: opportunity cost and frequency of good investments.
Suppose you have mastered analyzing simple investments. If that is all you choose to do, you are then bound to this opportunity set and would have to forego potentially higher-return investments that require a different skill-set. Additionally, really good investments are rare. What if for a stretch of time nothing meets your criteria within your circle of competence? If you want to remain disciplined and stick to your process (and you really should), you just have to keep looking and sit on the sidelines until you find something. On the other hand, had you had a broader circle, you might have been able to look in other places and find attractive investments there.
Of the three criteria (behavioral comfort, inherent predictability and domain expertise), the second one is absolute, but the first and the third both vary between people and can be expanded. As I continued to invest I noticed the importance of quality, both in businesses and in management teams, and have become willing to pay more, up to a point, for high quality companies. Conversely, I noticed that many cheap stocks are really cheap for a reason, or have futures that are far worse than their past financial histories would suggest. This has caused me to broaden my circle of competence and evolve my process over a period of years to the point that I am as comfortable today in assessing intangible qualities of a business as I was in my original, much narrower, circle in my earlier days.
So how much expansion is too much? There are two dangers. The first is what is sometimes referred to as “fancy play syndrome.” This occurs when an advanced investor is no longer content with generating good returns via simple (to them) means, but wants an intellectual challenge and because of overconfidence tries to make investments with a higher degree of difficulty than he can handle. Remember, it’s not how advanced you are that is important – it is how your skills measure up to the task at hand.
The second danger is evolving your circle of competence not for fundamental reasons but because there is little in your current circle that meets your standards at a given point in time. Sitting on the sidelines being disciplined is no fun. Nor would most serious investors blatantly throw away their process and just tell themselves “I am going to be undisciplined today.” Instead, what I think sometimes happens is that investors get tired of waiting, or get tired of watching others appear to make outsized returns in a given area, and convince themselves that something is within their circle of competence when it really is not.
Today, some intrinsic value investors are stretching beyond their circle of competence (although they may have convinced themselves they have actually achieved a higher level of investment sophistication) to justify owning high-expectation stocks because of the market’s multi-year preference for high-growth companies. Maybe they are right and poor souls like myself who choose to remain disciplined within their old circles of competence are merely unable to reach their rarified heights of investment acumen. Or perhaps, they are falling prey to behavioral biases and convincing themselves that what they are doing is an evolution of process while it’s really giving in to their inability to abstain from action and a subconscious fear of missing out. Time will tell.
Regardless of how far you want to expand your circle of competence, there is one thing that I believe you absolutely must do to be successful: you should only improve your process in general terms rather than when you are considering a specific investment. At any given time you need to be disciplined and operate within your current process. When you have improved your process by thinking about it rigorously from first principles, and not because any specific investment is putting pressure on you to deviate, only then should you start applying your improved process to new investment opportunities.
It’s not the size of your circle of competence that matters, but rather how accurate your assessment of it is. There are some investors who are capable of figuring out incredibly complex investments. Others are really good at a wide variety of investments types, allowing them to take advantage of a broad set of opportunities. Don’t try to keep up with the Joneses. Figure out what feels comfortable, and do that. If you are not quite sure whether something is within your circle of competence or not – that in and of itself is an indicator that it’s better to pass. After all, to quote Seth Klarman’s letter to his investors shortly after the Financial Crisis of 2008, "Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return."
Article by Gary Mishuris, Behavioral Value Investing