In his 1996 shareholder letter1, legendary investor Warren Buffett wrote:
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.
Everyone builds up knowledge on certain areas throughout their lives. Some areas are widely understood, while others require more specific expertise.
For example, most of us have a basic understanding of the economics of a restaurant. You buy or rent a place, furnish it, and hire employees to cook, serve, and clean.
From there, it’s all about setting the right prices and generating enough traffic to make a profit on what you serve after your expenses have been paid.
The menu, atmosphere, and pricing will vary, but all restaurants follow the same economic formula. That basic knowledge, combined with some understanding of accounting and a little bit of study, is enough to allow you to evaluate and invest in restaurants. It’s not too complicated.
However, most of us don’t have the same understanding of how a biotech drug company works. And, according to Buffett, that’s perfectly fine. To be a successful investor, you don’t have to understand every business you come across. But you have to understand what you know—your circle of competence—and stick to those areas.
Buffett’s business partner Charlie Munger applies this idea to life in general:2
You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.
To give you a concrete example, I’ll share my circle of competence. It contains three major areas:
Each workday that I learn something, write something, and promote what I wrote, I consider a day well spent. Conversely, each workday I stray outside of these three areas, I generally see as a day poorly spent.
That’s the power of a well-defined circle of competence. It makes you a lot less vulnerable to the Dunning-Kruger effect. You’ll be acutely aware of what you know and what you don’t know. And that helps you spend your time, energy, and resources much more efficiently.
What’s your circle of competence? Do you know its boundaries? And are you operating inside of it?