What I'm reading: Circle of competence and how Warren Buffett avoids problems

Understanding your circle of competence helps you avoid problems, identify ways to improve, and learn from others.

But when ego, not competence, drives what we do, we have blind spots.

If you know what you deeply understand, you know where you have an edge over others.

Knowing what you don’t know, helps you understand what to avoid and improves decision-making and outcomes.

The concept of the circle of competence has been used over the years by Warren Buffett, to focus investors on operating only in areas they know best.

His well-known Shareholder Letter is a great example:

"What an investor needs, is the ability to correctly evaluate selected businesses.”

Note that word, “selected”.

You don’t have to be an expert in every company or even many.

You only have to be able to evaluate opportunities within your circle of competence.

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

Circle of competence

This week’s mental model is simple.

Each of us, through experience or study, has built up useful knowledge of certain areas of the world.

Some areas are understood by most of us, while some areas require a lot more speciality.

For example, suppose you take your car to a mechanic.

This is an alien land to most of us; so, we are subsequently open to be taken advantage of because of the asymmetry of knowledge.

Until recently, nearly all financial products and investments you might be pushed into had commissions attached to them - in other words, the ‘adviser’ made more money pushing you into one colour than the other, regardless of the wisdom.

In both these cases, we’re not on solid ground until we know, in some detail, the way that sector works and how incentives can drive behaviour.

That basic knowledge can enable you to evaluate and improve decision-making.

But as Buffett so eloquently put it, we don’t 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.

At AES, we believe that within investments, it’s important to understand the following basics:

1. Accept the stock market is tough to beat
2. Understand risk and return are related
3. Don’t put all your eggs in one basket
4. Focus on the investment mix
5. Keep your costs low
6. Control your emotions and think long-term
7. Only ever trust a certified (and verified) fiduciary

Circle of competence of course applies outside of investing.

Charlie Munger takes this concept outside of business completely, and into life in general.

The essential question he sought to answer was: Where should we devote our limited time in life, to achieve the most success?

Charlie’s simple prescription:

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.

And that’s as close to certain as any prediction that you can make.

You have to figure out where you’ve got an edge.

And you’ve got to play within your own circle of competence.

So, the takeaway is simple and clear.

If you want to improve your odds of success in life and business, then define the perimeter of your circle of competence, and operate inside it.

Over time, work to expand that circle but never fool yourself about where it stands today, and never be afraid to say, “I don’t know."