Circle of Competence

Today, we are going to talk about “circle of competence” – a concept, which many successful people say, is of paramount importance.

Let’s break the words and try to figure out what does this phrase mean. So there is the word “circle”. We know that circle is a geometric shape with curved but definite boundaries. Then there is the word “competence”. Competence means knowing something extremely well. So putting the terms together, we can figure out that the phrase “circle of competence” stands for a circle that is a geometric representation with things that we are well aware of, inside it; and things that are alien for us or we have little knowledge about, outside it.

The concept of circle of competence was first introduced by none other than Mr. Warren Buffet in one of Berkshire Hathaway’s annual report. He strongly believes that one should operate within their circle of competence (i.e. do something only if they know about it properly) to reduce the chances of making mistakes and thereby reduce their risk.

Just look at the people around you and observe them. There is at least one thing that a person is expert in. For example, a chef is expert in cooking and a painter is expert in painting. If you give the chef a brush and a canvass and ask him to make a portrait of yourself, you would definitely be devastated with what the end product on the canvass will be!!! His brain is wired over the years to think about spices and vegetables and not about pencil strokes and colour-schemes.

So it is best for a painter to paint and a chef to cook as he has gained mastery over it due to rigorous practice and experience gained over time.

Sounds pretty simple, right!

But wait, there is a catch here. How do you know where the boundaries lie? How do you know what lies inside it and what lies outside? And many similar questions will start popping into your mind once you begin trying to apply this concept in your life.

To simplify things, let us go step wise.

STEP 1:

The first step to do is to list down all the things that you have learned so far. Don’t just simply write mathematics, painting, dancing, buying a car, buying a stock, etc. Try to write it in as much detail as possible. For example, write down trigonometry, Cherial painting, Belle dance, buying a sedan in India, buying a mid cap stock in FMCG in American equity markets, et cetera.

This is because “buying a car” and “buying a sedan in India” are very different. Here is an example for you to understand it better. Mr. Williams, who lives in India, had recently purchased a sedan car for himself. His friend, Mr. Gupta, who lives in Canada, seeks for his advice to buy a car. Mr. Gupta has a personal inclination towards hatchback cars and wants to buy one of the hatchback cars available in Japan. So here, Mr. Williams will feel that he knows how to select a car because he has recently purchased one and so, he will, with pure intensions in his heart, give advice to his dear friend, Mr. Gupta. But he fails to realise that the factors of buying a hatchback car in Canada are very different and he no longer is in a position to provide sound advice.

This is what most people fall prey to. They feel that they know something well whereas they actually know only a part of it.

STEP 2:

Now, we have to start segregating items out of this list.

Out of the list that you had previously prepared, put the things in which you have a very vast knowledge and are updated with the latest happenings in that field under “LIST A”.

There will be some things about which you will be really passionate, things in which you have a natural ability to apprehend quickly and things in which your curiosity is awakened and a lot of good and sensible questions pop up in your head, but unfortunately these things haven’t been able to make it to LIST A. Put all these things under “LIST B”.

Neglect the rest of the list.

Now To find circle of competence, we need a circle. That circle must contain all the items under LIST A.

I personally prefer to draw another circle around the circle of competence and name this belt as “BELT OF MINESWEEPER”, the name is derived from a game “Minesweeper”. Do you remember this all-time-favourite childhood game? It had bombs hidden all over the place and you had to carefully flip the cells that didn’t have bomb under it. Once you flip a cell, you get a vague idea about whether there is a bomb in the surroundings or not. In the start, you kind of play a blind game (and have a very high risk of bomb blast). But as you proceed in the game, you get more and more clarity about the cells where danger exists and those that you can freely turn.

Relating this same analogy to the concept of “circle of competence”, I have come up with this “belt of minesweeper”

The belt of minefield is the area in which you know some things but a lot of things exist that about which you are unaware of. One wrong step and the bomb can blast. But this belt is something that interests your personality and you have an ardent desire to explore it. But remember, “half-knowledge is dangerous” as it makes you feel like you know something when you actually don’t know everything about it.

So be very careful about what you put inside your circle of competence and what you put in the belt of Minesweeper.

Now in the upcoming years, try to master the things that lie in the belt of Minesweeper so that it can go into your circle of competence and you can actively start using that knowledge in your decision making process. Remember this: “Do not make any decisions based on your knowledge of things lying in the belt of Minesweeper! Because there are things that you have no idea about and it can make you decisions go down the wrong path.

Everything outside your circle of competence is something that you are not equipped with to make any decision on. So if something outside your circle of competence comes up and you don’t have time or don’t want to include it in your circle of competence, take help from someone who has it in their circle of competence.

It is ok to pay for receiving good help for things that are not in your circle of competence because if you work on things within your circle of competence, you are bound to earn much more money than others (not to mention, the satisfaction that you get from working). This is basically how the human society works. We all master something that we are fond of and depend on others to guide us when life throws things that are out of our circle of competence. Not only the human society, but even the tiniest cell of our body works on this fundamental principle!

Now, another question that comes up is:

“What if I have learned nothing till now and want to start fresh on developing my circle of competence. I am just a kid and don’t have anything in which I am the best?”

Well, there is a famous quote, “Fish in the pond that has many fishes” as it would increase your chances of catching a fish. I’d suggest that first try out things of your passion and deep desire, where there are a lot of opportunities and where the base rate of success is very high. If it interests you, go on and delve deep into it. If not, leave it and move on… There is a plethora of mesmerizing things out there left for you to try.

Once you have your circle of competence, don’t worry about its size. Size doesn’t matter. What matters is you have a clear idea of where the boundaries lie and dare not step outside it.

In field of Finance, you need to apply this concept in the same way…

First of all, you will figure out what is your circle of competence.

1. Do you understand a particular industry?

PHILIP FISHER said, “What really counts in determining whether a stock is cheap or overpriced is not its ratios to the current year’s earnings, but its ratio to the earnings a few years ahead.”

Knowing things of the present is simple and anyone can do it. But the real task lays in the future assumptions we take while evaluating a business.

And to make a sound assumption or judgement about a company’s future earnings, you have to understand the Modus operandi of that business, the threats that it faces, the advantages that it has, demand and supply scenario, and a lot more stuff. Only if you understand it, you can see where the industry trends point to – in the coming 5-10 years.

Carefully decide whether you know a particular industry or not. Don’t make a mistake like Mr. Williams!

1. Do you understand emerging markets or developed markets?
2. Do you understand equities, debt, currency, et cetera markets?

You need to answer these and many more questions and decide your circle of competence.

Last, but not the least, I would like to remind you that the world is not static and is evolving at a very quick pace. So once something enters your circle of competence, you can’t just sit and relax. You need to be on your toes and keep yourself updated with the things going on and how the market dynamics are changing or else it will soon be out of your circle of competence without you even realising it!

So let’s buckle up and work hard towards building a very strong circle of competence!