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Tuesday, August 4, 2009

What is your Circle of Competence?

'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 E. Buffett

If you are able to answer the question truthfully and without letting your ego come in the way, you will be well on your way to becoming a successful investor. Trouble is, even seasoned investors are some times unaware of how to answer the question.

So, here are some guidelines in helping you to find out.

Think about your family. Your parents, relatives, in-laws, cousins. What kinds of activities have they been associated with. A doctor in the family? She'll be able to help with pharmaceutical and medical devices companies. In the textiles business perhaps? He may help you understand all about synthetic and man-made fibres.

What about your education, training and work experience? A civil engineer? You will know about construction companies, cement companies, road projects. An electrical engineer? Power generation and distribution, electrical cables and meter companies, electrical appliances will be in your knowledge base.

Your upbringing, education, work experiences, financial stability will all influence your behaviour patterns, risk tolerance, ability to take independent decisions and awareness about what you can do, and what you can't.

That creates your Circle of Competence. Your knowledge base. It is entirely an individual's circle. Only you know what you know and how much you know. Never confuse familiarity with knowledge.

I may use a fancy Mach III Gillette razor every morning. But I have no idea how Gillette runs its business or if a hike in steel prices will dent its profits significantly or not.

You may be a Bharti Airtel customer for a number of years. You like their service and their all-India presence and fast growth. So you get excited by the announcement of a maiden dividend and stock split and pick up 200 shares. Then you hear about the MTN acquisition, which seems to be going nowhere. Is that good, or bad for Bharti shareholders? Should you sell, hold or buy more?

Before you buy a single share of a company, make sure you have a basic understanding of how that company operates. What do they sell? Who do they sell it to? Who are their competitors? Are they in a sector that is growing fast, or is it a cyclical business? If you don't have this knowledge, don't buy the share.

What if your Circle of Competence is very, very small? Say you have worked for 15 years in the software industry and really don't know much about anything else. You can still earn a fortune by buying and selling shares of Infosys, TCS, Wipro.

But that will be putting all your eggs in one basket. Better to have several baskets. How? By increasing your Circle of Competence. Meet people. Join investor groups. Learn about new businesses and industries. And read, read, then read some more. Books, magazines, web sites - information is all around you.

Be sensible in gathering information. Don't suddenly try to become an expert about the Shipping industry and the Baltic Dry index. First look at businesses for which you have developed software. Chances are, you have in-depth knowledge about their operations and processes already.

Just sticking to your Circle of Competence may be a good idea, because it takes out the guesswork from stock investments. But it is not enough. You still need to be able to identify good sectors and companies through fundamental analysis. Then use technical analysis to determine if this is a proper time to buy or sell.

Related posts

How to pick Stocks for Investment - Part III
What exactly is the Margin of Safety?

4 comments:

Eswar Santhosh said...

"Never confuse familiarity with knowledge"

Golden words, but which should be often repeated.

Alkesh said...

good theories which are not prectical.

There are certain type of events which will effect investors badly.. but those informations are not available to even employee of company, how can a invest can get. other information is useless mostly. and doesnt make big different either u get or not.

Let say, I hold stocks of NTPC, i know its in power sector. and i m happy, if something is wrong, I cannot know that information, unless stock hits bottom.

same was case with SATYAM. reality is reality

SG Money Mind said...

Sometimes you learn and develop the competencies. While I started to analyse the financial sector stocks, I had difficulty to understand the intricacies. Persistence paved the way to learn about each parameter and then have a better view.

While I still have a long way to learn several things, I am still happy that my view is not much based on the quarter to quarter results of companies. That helps me a lot to time my investments instead of getting carried away by the day to day movements of the stocks.

Subhankar said...

@Eswar: Appreciate your comment.

@Alkesh: By projecting the specific into the general, you seem to have missed the point.

Peter Lynch practised the 'Buy what you know' theory. Buffett follows the 'Circle of Competence' theory. Both seem to have done pretty well.

Do you hold NTPC? Then answer the following questions to yourself. What is their plant load factor? Is it better or worse than Tata Power or CESC? What are their generation losses? How does it compare with competition? What are their debtor days vis-a-vis competition?

The more you have answers to similar questions, the less you will be exposed to event risks.

I'm glad you mentioned Satyam, because it is a perfect example of the 'Circle of Competence' theory.

Back in the early 1990s, when Satyam wasn't that well-known outside Hyderabad, I met their CEO. Found out that neither he, nor the company promoters had any prior experience in the computer industry. I had more than a dozen years of computer industry experience then, and immediately decided not to touch their shares. Stuck to Infosys and TCS, and never regretted that decision.

@SGMM: Agree with you. For long term investment success, one has to continuously keep pushing the perimeters of the 'Circle of Competence' to make the circle larger.