Inverting Your Circle of Competence

The key to successful investing isn’t the successful memorization or rote application of various investment principles. Rather, it is the internalization of such principles and then bending them to fit your unique perspective and character. In this post, I am going to examine three value investing concepts: Buffett’s “circle of competence”, Munger’s “invert, always invert” and Klarman’s “incomplete information.”

The concept of an investor’s circle of competence, popularized by Warren Buffett, states that investors should limit their investments to areas or industries where they know more than the average investor. A very simple principle that basically says don’t invest in stuff you know nothing about. It’s similar to Peter Lynch’s advice to invest in what you know.

On a recent podcast, I was asked about my circle of competence and surprisingly, it was hard for me to answer. Obviously, if you have 20 years experience in a particular field, there’s a possible circle of competence but my experiences have been far-ranging, from software to music to politics. I began to mumble about the energy sector, which I’ve studied in-depth but I’ve never set foot on a drilling rig or seen crude oil in my life so it seems strange to consider myself an energy expert.

There are inherent limitations to the circle of competence concept: how can an investor prove to himself that he’s truly competent in a given area? How does an investor expand that circle if she’s always focusing on areas she already knows well?

The answer hit me when I inverted the question. The concept of inversion as it applies to investing comes from Charlie Munger and his infamous exhortation to “Invert! Always invert!”

The concept of inversion can be found in many other disciplines. For example, beginning drawing students who think they “can’t draw” are often told to stop trying to draw the object and instead, draw the negative space around the object (if you’ve never tried this, it is shocking how good your drawing can be using this technique). In science or logic, one may approach a problem and its solution by trying to prove it is false, not that it is true.

My approach to circle of competence centers around inverting the question: when studying an investment prospect, it is more important to focus on your circle of incompetence! Instead of approaching the investment from a position of confidence (I know this industry, company, etc.), I view it from a position of uncertainty and insecurity. A company’s financials may look strong but it doesn’t tell you anything about their culture, internal systems, external systems, future products pipeline, management competence, legal exposure, etc. And unless you’re inside (and even then), there’s a limit to how much you can know about the company.

I believe this inverted approach forces an investor (me, at least!) to be mindful of the risks I’m taking. Instead of thinking that I’m competent and “own this place”, I see it more like a minefield, with each step a potential blow-up in my portfolio.

Seth Klarman, in his famous $1000 book, Margin of Safety, discusses the concept of incomplete information. Investors have to be comfortable with putting money at risk without complete knowledge of their investment. The trick is to know when you know enough. In fact, Klarman suggests knowing more than enough is wasteful as time is the most precious resource we all have.

In a way, this whole discussion bleeds into Warren Buffett’s oft-stated (if little followed) preference for simplicity. I often research companies in fields where I have absolutely no experience or circle of competence. If in the course of my research, I am able to get comfortable enough with the company, its industry and prospects, I make the investment. If not, it goes in the “too-hard” file. But if you only stuck to your knitting, would you even look at it in the first place?

I’m reminded of David Dremen’s anecdote of the Clorox analyst who could spout off any number of minute information or statistic regarding the company but was completely ineffective in recommending good buy/sell points on the stock. Circle of competence, indeed!

Finally, remember to take all these value investing truisms by Buffett, Munger, Klarman, etc with a hefty grain of salt. Many times, their statements will contradict their other statements or actual actions. Keep in mind, they’re probably too busy digging up great investments to actually sit down and lay out a coherent investment philosophy. They’re not academics, after all! It’s up to the individual to tailor the gurus’ wisdom to their own investment style.

3 Responses to “Inverting Your Circle of Competence”

  1. Jae Jun Says:

    Fantastic article. It really is hard for most people to pinpoint their circle of competence. If someone asked me that same question, I would probably be stumped. But I do believe my own circle has grown a little because I have no expertise in just one industry.

    I always approach an investment knowing there is much to learn which helps to prevent overconfidence.

  2. The Enlightened American » 135th Edition - The Festival of Stocks Says:

    [...] Inverting Your Circle of Competence [...]

  3. Jim Says:

    Fantastic article and one an idea that I’ve always shared.

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