Circle of Competence – stick to what you know and understand

Warren Buffet’s partner, Charlie Munger, came up with the expression circle of competence. According to Munger, one must always stick to what they know and understand as an investor. You take a greater risk by going outside your area of expertise.

Although it is common sense, we often see examples of the opposite where acquisitions based on poor strategies lead to buyers paying exorbitantly high prices and investors putting their money in companies that they don’t understand.

George Soros saw everyone earning on dot-com shares in the late 90s, which led him to invest in these companies. When dot-com stocks crashed in March 2000, his hedge fund suffered massive losses. Why did that happen?

Because he was outside his circle of competence. High intelligence doesn’t prevent you from making mistakes. Therefore, you need to trust yourself and not what others say or do.

Fewer misinvestments mean more returns and you make fewer mistakes by purely sticking to what you know. If you have in-depth knowledge of stock A, then there’s no reason why you should invest in stock B that you don’t know much about.

You only have limited time and you can’t be good at everything. Therefore, you must allocate all your capital within your area of expertise.

There’s no guarantee that professional managers are better able to stay within their area of expertise than you are. This is evident from Soros’ example.

Remember that they are more interested in keeping their well-paid jobs and are, therefore, scared to take chances. Hence, they choose investments that are close to the benchmark index. Many studies show that various active funds are in reality passive funds, but they still charge high fees from their customers.

To ensure a good return, you must think outside the box and deviate from the benchmark index but stay within your area of expertise at the same time.