Warren Buffett came up with the idea of the "circle of competence," which has helped him get great results and make a lot of money. But what is it?
To make smart choices, you need to know what your circle of competence is. The idea behind this is that you should focus on things you know a lot about. Working within this ‘circle’helps you avoid more problems, learn from others' experiences, and quickly spot possible opportunities.
Socrates said;
The only true wisdom is in knowing you know nothing.
Getting to know your circle of competence
Differences between what someone thinks they know and what they actually know can be caused by a cognitive blind spot or a lack of humility. The skills needed to do the right thing are very similar to the skills needed to decide if what you're doing is right. In terms of money, Warren Buffett often stresses how important it is to stay within one's area of expertise.
As an investor, you need to know how to judge a business correctly. You do not need to be an expert on everything; just know what you are good at. The circle's size is not important; what matters is that you know where its edges are.
Understanding what you know and being aware of what you don't know is more important than how big your circle is. The goal is not just to make a lot of good choices, but also to make as few bad decisions as possible. Everyone has an area where they know a lot about a subject. This is called your "circle of competence."
It doesn't matter how big that circle is. It's important to know when you're getting close to the edge. When it comes to your area of expertise, you have an edge. As you get closer to the boundaries (the limits of what you know), your advantage starts to fade. Not only does your edge go away when you cross the line, it also goes to other people. All of a sudden, you're playing in a place where other people are better than you.
What does the Circle of Competence mean?
Using the Circle of Competence as a mental model can help you figure out what specific areas of knowledge or experience each person has. In some part of the world, everyone has learned useful things. Finding out your skills will help you avoid places where you don't know much about them, which will lower your risk.
Being a Grandmaster at chess means that you are very good at the game, but that doesn't mean you are good at other things, like cooking. In fact, people who are very good at one thing often end up being very bad at something else.
I want to think about things where I have an advantage over other people. I don’t want to play a game where people have an advantage over me. I don’t play in a game where other people are wise and I am stupid. I look for a game where I am wise and they are stupid. And believe me it works better. God bless our stupid competitors. They make us rich. - Charlie Munger
How to find your circle of competence?
To figure out your area of ability, being honest with yourself is the most important thing. This could come from school, work, or just everyday life; everyone has an area of expertise. For instance, a lawyer who has spent decades learning law and using what he has learned in court will have a circle of competence that is based on law. In that area, it gives them a clear edge because it's very specific.
It's crucial to know what you're good at and what you're not. This is called your "circle of competence." It's like playing a game of cards: you need to know when to play your best cards and when to fold. Understanding your circle of competence helps you take calculated risks and grow intelligently.
For example, if you're a creator who's great behind the scenes, it's best to stick to your strengths, like blogging, before branching out to videos. If you're a US investor who's not familiar with tech or Chinese markets, it's risky to invest in stocks like Alibaba without knowing what you're doing. And if you're a litigation student who wants to switch to software engineering, it's important to get the necessary training before diving in.
It's important to stay within your circle of competence to achieve the best results. If you're into video games, you might consider investing in game companies. If you're a software engineer, you could use your knowledge to select software stocks with high growth potential. At Stock Discovery, we don't invest in pharmaceutical stocks because we don't have the expertise to analyze them.
When you have to make important decisions or reduce risks, it's best to stay within your area of expertise, known as your "Circle of Competence." But if the risks are lower and there is room for creativity and innovation, it can be beneficial to step outside of your comfort zone. This can lead to unique and effective solutions. It's important to consider the level of risk involved before deciding whether or not to venture beyond your area of expertise.
Remember that you can always expand your circle of competence once you've identified it.
Why is it important?
The circle of competence helps investors in many ways, but the main one is that they don't make (as many) mistakes that cost a lot of money. Not every financial choice you make will be a good one, but if you stay within your circle of competence, you can greatly reduce the chance of losing a lot of money. You make every choice based on what you know and what you've learned from experience in that area. It's easier and smarter to make choices when you use these two things.
The other benefit is that you can use what you know to get things done. If you know your circle of competence, you can use it to make smarter choices about investing that other people might not be able to make. If you focus on what you do well, you'll be ready to take advantage of a good chance when it comes up.
Let us end with one last thought from Charlie Munger.,
"The whole trick of the game is to have a few times when you know something is better than average and invest only where you have that extra knowledge. If that gets you a few opportunities, that's enough."
We couldn't have said it better.
Know the edges of your circle of ability and work well inside it to improve your chances of success in business and life. Over time, try to make that circle bigger, but don't fool yourself about where the edge is. Also, don't be afraid to say, "I don't know."