The Circle of Competence

The most valuable investment decision most investors never make is the decision not to have a view.

Every week brings another opportunity that appears to deserve attention. A fund manager requests a meeting. A friend mentions a private investment. A new technology dominates the headlines. A broker calls with an idea described as timely, differentiated or difficult to access. The instinct is to form a view. We read the material, ask a few questions and begin forming an opinion. The assumption is so natural that we rarely notice it: if an opportunity crosses our desk, it deserves our judgement.

Before deciding whether an opportunity deserves capital, it is worth deciding whether it deserves our judgement at all.

Warren Buffett and Charlie Munger popularised the idea of the circle of competence. It is one of their most enduring contributions to investment thinking, yet it is often misunderstood.

The circle is defined less by what we know than by where our knowledge stops.

A small circle drawn honestly is more valuable than a large one drawn optimistically because it tells us which questions we have earned the right to answer, which require someone else’s expertise and which belong, without embarrassment, in the too hard pile.

The circle of competence and the too hard pile are really two sides of the same discipline. One defines where our judgement is likely to be reliable. The other gives us permission to walk away when it is not.

Buffett has often described keeping a too hard pile. It is not a collection of poor businesses or unattractive investments. Many opportunities placed there may go on to produce excellent returns. That is beside the point. They are opportunities where we simply do not trust our own judgement enough to act.

Drawing that boundary honestly is harder than it sounds. We mistake familiarity for understanding. We use a technology every day and assume we can value the companies behind it. We spend a weekend reading about an industry and begin to feel comfortable discussing its prospects.

Curiosity is valuable. It is often how a circle of competence begins to expand.

The mistake is allowing curiosity to become conviction before competence has caught up.

Competence is surprisingly specific. A successful entrepreneur may understand the economics of the business they built without being able to value every company in the sector. A property investor may know one local market intimately while having little basis for judging commercial real estate in another country. Years of experience in one corner of finance do not automatically transfer to every other corner.

We can understand far more businesses than we can value well.

Artificial intelligence makes that distinction easier to miss. Annual reports can be summarised in seconds. Industries can be mapped in minutes. Research that once required days can often be completed in an afternoon. Becoming informed has never been easier.

Becoming competent still takes time.

Information can be gathered almost instantly, but judgement still has to be earned through repeated contact with reality: making decisions, seeing how they play out, discovering what we misunderstood and gradually learning which variables matter more than they first appeared.

The circle of competence is therefore not fixed. It expands slowly through experience, but it can also contract as industries evolve, technologies change or our knowledge becomes dated. Yesterday’s competence is not automatically today’s competence. That is another reason to revisit its boundaries from time to time rather than assuming they move only in one direction.

When we do not define the boundary ourselves, the investment industry defines it for us. The portfolio gradually becomes a record of the opportunities that crossed our desk rather than the decisions we deliberately chose to make. Without noticing, we begin responding to the flow of ideas around us instead of allocating attention according to our own priorities.

Early in our investing lives, we tend to measure ourselves by how many opportunities we can understand. Experience usually moves in the opposite direction. We become increasingly selective about the questions we are prepared to answer because we gradually recognise that every opinion carries a claim about our own judgement. Most opportunities simply do not justify making that claim.

One advantage of managing our own capital is that we do not have to play every game. We do not need an opinion on every asset class, geography or investment strategy. We only need enough good decisions to achieve the purpose our capital is meant to serve. That freedom is easy to underestimate. It allows us to ignore opportunities that are outside our competence without worrying whether everyone else is participating.

Every opportunity presents two questions. The obvious one is whether it is an attractive investment. The more important question comes first.

Am I the right person to answer it?

If the answer is no, the most intelligent investment decision may already have been made.

Every investor has a circle of competence. The question is not whether it is large. It is whether we know, today, exactly where it ends.

Most expensive investment mistakes begin just beyond that boundary.

Understanding something is not the same as having an edge. We may understand a business, an industry or an asset class very well and still have no reason to believe our judgement is likely to outperform the market’s.

That is where the next decision begins.