Stay­ing in your cir­cle of com­pe­tence

Know­ing what in­vest­ment ar­eas you are knowl­edgable about and stick­ing to those ar­eas is cru­cial to long-term suc­cess.

Finweek English Edition - - MARKETPLACE - Edi­to­rial@fin­

i’ve been re-read­ing a few older Berk­shire Hathaway an­nual let­ters writ­ten by War­ren Buf­fett and found this gem in his 1996 let­ter: “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.”

It was sup­pos­edly in­spired by a com­ment by IBM founder Tom Wat­son, who said: “I’m no genius. I’m smart in spots – but I stay around those spots.” It got me to won­der­ing how of­ten we leave our cir­cle of com­pe­tence as in­vestors. I sus­pect far too of­ten.

First, com­plete novices to in­vest­ing should start with the ab­so­lute ba­sics and learn about exchange-traded funds (ETFs), and in­vest in them ex­clu­sively. For most peo­ple this is more than enough. Buy some ETFs ev­ery month, come back in a cou­ple of decades and we’ll have cre­ated wealth. Mis­sion ac­com­plished.

But most of us (and I in­clude my­self in this cat­e­gory) start at the very com­pli­cated and risky end – trad­ing. We dive into de­riv­a­tives when we don’t even un­der­stand mar­kets, and we ex­pect to be able to make prof­its in su­perquick time. No­body ever does.

Hav­ing started with ETFs, some of us will then move on – those of us who are num­ber nerds, who love piles of num­bers that we can pull apart and try make sense of.

But even then we need to stick closely to our cir­cle of com­pe­tence. For ex­am­ple, when in­vest­ing off­shore I only buy ETFs, be­cause my knowl­edge of the hun­dreds of thou­sands of com­pa­nies off­shore is lim­ited. On the lo­cal exchange I have been watch­ing most com­pa­nies ei­ther since list­ing or for the past 20 years. I take it a step fur­ther. Within JSE-listed com­pa­nies there are a lot of ar­eas that I am no ex­pert in, so I ei­ther stay away or get ex­pert help when dig­ging into cer­tain sec­tors; in­surance be­ing one of them.

A rel­a­tively easy space is min­ing, but we still need to un­der­stand re­serves, head grades, op­er­at­ing mar­gin and the lever­age im­pact of this mar­gin. None of it is rocket sci­ence, but we need to be­come ex­perts in the field.

Then, I knew noth­ing about min­ing, but it was a large part of the lo­cal mar­ket back in the 1980s, so I set out to get smarter. I read books, spoke to min­ers, read min­ing com­pany re­sults and an­nual re­ports, gen­er­ally be­com­ing a lot smarter about the eco­nom­ics of min­ing. The beauty of this knowl­edge is that now, some 30 years later, I still have it and can use it as and when re­quired.

So, as new­bies start­ing out, we need to recog­nise our lack of knowl­edge and not be afraid of it. Rather stick to what we do know and slowly and care­fully build our knowl­edge cir­cle. When we en­counter ar­eas about which we have lit­tle knowl­edge, we need to ad­mit that fact and ei­ther seek ex­pert help or move on to ar­eas we are ex­pert in. We do not need to be an ex­pert in ev­ery field, and we’re bet­ter served by tak­ing Tom Wat­son’s com­ments to heart: Be smart in sec­tors. Know what those sec­tors are and stick to them.

And, as I men­tioned in the be­gin­ning, start with ETFs. Be­come an ETF ex­pert first be­fore mov­ing into in­di­vid­ual sec­tors.

When we en­counter ar­eas about which we have lit­tle knowl­edge, we need to ad­mit that fact and ei­ther seek ex­pert help or move on to ar­eas we are ex­pert in.

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