How To Find Your Circle of Competence
The idea of investing in what you know isn't just some catchy phrase—it's a fundamental principle that can make or break your success in the market.
When you invest in something that’s outside your wheelhouse, you're essentially playing a game of chance. It's like the Las Vegas Strip on a Friday night—it's risky, and the chances of making poor decisions are high.
This becomes especially apparent when the market takes a downturn. The uneasiness you feel when your stocks are down can stem from not having enough confidence in your investments, which comes from not really understanding the companies you've invested in.
This is why you should stick with what you know, or as Warren Buffett would say, stay within your Circle of Competence. But how do you find your Circle of Competence?
It's about recognizing your strengths, understanding where your expertise lies, and staying within that realm. Buffett says, “The size of that circle is not very important; knowing its boundaries, however, is vital.”
A great place to start with all of this is to look at your own consumer habits. Think about the products and services you use regularly. What brands do you prefer? Where do you shop?
Your consumer experience can be a goldmine of investing insights.
When you're familiar with a business as a customer, you'll have an easier time identifying its competitive advantages and can understand why you—and countless others—choose to support it. It’s easier for you to see what sets these businesses apart and keeps customers coming back for more.
You can also invert your outlook. Instead of trying to identify what you do know, start with what you don’t, and narrow it down from there.
With that in mind, there will be times where you’ll have to find out what you don’t know the hard way. Sometimes you have to step outside your Circle of Competence to learn where the boundary is.
Every single one of the losses I’ve incurred in my investment journey so far have come from not REALLY knowing what I was investing in, and these were all some of my earliest investments.
This was the case with 3M (MMM), and it was true with AT&T (T) and Verizon (VZ). I had unknowingly stepped outside the Circle.
On the surface, I knew what these companies did, and had a basic understanding of how they made money. But it didn’t go much beyond that.
Compare that to something like Apple (AAPL). I’ve been an avid customer of theirs for well over a decade at this point—as I’m typing on my iMac with my MacBook, iPhone, and iPad all next to me.
As a customer, I understand why their customers love their products.
It’s the seamless ecosystem, the App Store, and the brand, among many other intangibles. Those are all things I might not understand as well if I was an Android user.
The bottom line is this: When you invest in what you know, you make better decisions. You're less likely to rely on speculation, and instead you use your edge to identify potential opportunities.
Of course, there will always be new things to learn, and you’ll inevitably step outside your comfort zone from time to time.
When you do, it can be a great learning experience that hopefully you don’t have to pay too much “tuition” for, and the sooner you learn where the middle of your Circle is, the better off you’ll be.
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