Understanding your Circle of Competence: How Warren Buffett Avoids Problems

Each of us, through experience or study, has built up useful knowledge in certain areas of the world. Some areas are understood by most of us, while some areas require a lot more specialty to evaluate.

The bits you understand well is your circle of competence.

For eg: Most of us understand the economics of a restaurant. That basic knowledge, along with some understanding of accounting would enable one to evaluate and invest in any number of restaurants. However, can most of us say we understand the workings of a microchip company or a biotech drug company at the same level? Perhaps not.

Buffet says we do not necessarily need to understand these more esoteric areas to invest capital. Far more important is to honestly define what we do know and stick to those areas. Our circle of competence can be widened, but only slowly and over time. Mistakes are most often made when straying from this discipline.

Circle of Competence applies outside of investing.

I’m no genius. I’m smart in spots—but I stay around those spots.

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. The size of that circle is not very important; knowing its boundaries, however, is vital.

You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. You have to figure out where you’ve got an edge.  

If you want to be the best tennis player in the world, you may start out trying and soon find out that it’s hopeless. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes intelligence. But after a while, you’d gradually know all about the plumbing business in Bemidji and master the art. That is attainable.