What is the circle of competence in investing?
The best time to invest in the stock market is when you don’t feel like investing in the stock market. When we invest in the stock market, we tend to seek social conformity. When we buy stocks and the rest of the market participants are not participating in the party, we become little hesitant because we may feel that what we are doing may be wrong or may go wrong in future, but on the other side when we buy stocks and everyone buys stocks, we get a sense of social conformity that, what we are doing is right. Investors who always seeks social conformity for their every action they take in the market generally tend to underperform the market because the reason is very simple, we cannot get a superior return by doing what everyone is doing in the market.
Investors have to resist the phycological pressure exert due to social conformity to take clear decisions. It is more difficult than it seems to be because we are unknowingly prone to social conformity. Social conformity is the sole reason for investor becoming over optimistic when things are going right and depressed when things are going completely in the opposite direction.
It is necessary to identify this fact and avoid it to generate more returns in the market. One of the ways to avoid social conformity is to be in our “circle of competence”.
Circle of competence
When Bill Gates and Warren Buffet first met each other in 1991, gates mother asked both of them to write one single thing that made them very successful. Warren and Gates without discussing with each other, spontaneously wrote only one word – Focus.
Investors can be very focused in selecting the companies when they have well defined circle of competence. In our circle of competence, we must clearly define what we understand and what we can understand. For example, if you are working in the banking industry, then you can understand the details of the banking industry. In this case, one must select the companies related to the banking industry because there is where our expertise lies. A man working is construction industry is far better in analyzing other construction industries rather than the banking industry.
Circler of competence defers from person to person. The risk comes when one tries to invest in companies where he cannot understand anything. For example, imagine what happens when a carpenter tries to play the piano.
Investors should clearly focus on what they understand. Circle of competence helps us from avoiding many risks and social conformity. For example, imagine that you are a banker and understand the banking industry and also you have invested in some bank stocks. If in case, any problem occurs in the bank you invested and the share prices fall down severely. You will be able to analyze the situation clearly than others because you know what is going inside the banking industry. You can even analyze if the crises occurred is temporary of permanent. If the crises is temporary and others are selling in a panic, you will get confident in buying more shares even if the price falls severely even further. This advantage that you get is enormous. That’s why it is clever to stay in our circle of competence. You can easily discard the companies out of your circle of competence and focus on only companies that you understand.
If we are investing in companies that are outside our circle of competence, and if by any case the prices fall severely, we may in a panic sell all our shares because we are unknowingly prone to social conformity. We may also think that if all are selling their shares then, there must be some problem in the company. instead of making independent decisions, we seek social conformity and this attitude is very hazardous for your portfolio returns.
The root of the circle of competence concept is from Warren Buffet’s shareholder’s letters (1996)
“What an investor needs is the ability to correctly evaluate selected businesses. Note that the 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.” -Warren Buffet
Playing inside in our circle of competence area would not necessarily generate any superior return but rather save us from catastrophic disaster.
Even when we are investing in the companies that we understand, we should leave some room for margin of safety.
Margin of safety
A margin of safety helps us in leaving some room for errors in our valuation approach. For example, if your valuation approach says that, this company is worth Rs 50 and the current price is also Rs 50, you should not suddenly jump and buy the stock. One should buy the stock having a large margin of safety. If You value company at Rs 50 and the current price is Rs 25, it means that you have a margin of safety of 50%. The larger the margin of safety, the greater the number of shares you should buy.
Buffet’s example of a margin of safety
You decide to build a bridge connecting two points and the maximum weight and load of the vehicles passing through the bridge is approximately 50 tones. Then you should think of designing the bridge in such a way that, it can withstand the load of 90-100 tons.
You will be in deep trouble if you build the bridge for carrying exactly 50 tones only. Margin of safety is very much important.
The key takeaway for investors
Investors don’t necessarily need to evaluate every stock or business. Investors must have their own circle of companies that they understand. Moreover, we also need some margin of safety in buying those business. unnecessarily investing in companies that we don’t understand is sure of losing your money in the market. First step of the investors is to define their circle of competence very clearly.