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.
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.