Understanding Your Circle of Competence

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Understanding Your Circle of Competence

If Warren Buffett cannot understand a company’s business, then it lies beyond his circle of competence, and he won’t attempt to value it. He famously avoided technology stocks in the late 1990s in part because he had no expertise in technology. On the other hand, Buffett continued to buy and hold what he knew. For instance, he was willing to purchase a large stake in Coca-Cola (KO) because he understood the company’s products and its business model.

Tech isn’t Buffett’s strong point

Although it might seem obvious that investors should stick to what they know, the temptation to step outside one’s circle of competence can be strong. During the technology stock mania of 1999, Berkshire’s return badly trailed the market’s return, and a number of observers commented that Buffett was hopelessly behind the times for eschewing technology stocks. However, Buffett has written that he isn’t bothered when he misses out on big returns in areas he doesn’t understand, because investors can do very well (as he has) by simply avoiding big mistakes. He believes that what counts most for investors is not so much what they know but how realistically they can define what they don’t know.