I remember sitting in a session with some athletes and the psychologist asked them to write down who they were. Most of the room associated their identity with being an athlete.
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Staying inside your circle
Most investors get into trouble when they step outside of what Warren Buffett aptly defines as their “circle of competence”
In fact, for years the concept of the “Circle of Competence” has been used by Buffett as a way to focus investors on only operating in areas they know best.
A quote from the investing guru sums it up nicely: “What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
The “circle of competence” concept is disarmingly simple.
Each of us, through experience or study, has built up useful knowledge on certain areas of the world.
Some areas are understood by most of us, while some areas require a lot more specialty to evaluate.
For example, most of us might have a basic understanding of the economics of a restaurant: You rent or buy space, spend money to outfit the place and then hire employees to serve, cook, and clean. (And, if you don’t want to do it yourself, manage.)
From there it’s a matter of generating enough traffic and setting the appropriate prices to generate a profit on the food and drinks you serve—after all of your operating expenses have been paid.
Though the cuisine, atmosphere, and price points will vary by restaurant, they all have to follow the same economic formula.
That basic knowledge, along with some understanding of accounting and a little bit of study, would enable one to evaluate and invest in any number of restaurants and restaurant chains; public or private.
However, can most of us say we understand the workings of a robotics manufacturer or a biotech drug company at the same level?
But as Buffett put so eloquently, we do not necessarily need to understand these more esoteric areas to invest capital.
Far more important is to honestly define what we do know and to stick to those areas.
The circle can be widened, but only slowly and over time.
Mistakes are most often made when straying from this discipline.
The simple takeaway here is 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.
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.”
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