The idea behind the Circle of Competence filter is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing. What could be simpler? And yet humans often don’t do this. For example, the otherwise smart doctor or dentist is easy prey for the promoter selling cattle limited partnerships or securities in a company that makes technology for the petroleum industry.
Charlie believes that investors who get outside of what he calls their “Circle of Competence” can easily find themselves in big trouble. Within a Circle of Competence a given investor has expertise and knowledge that gives him or her significant advantage over the market in evaluating an investment.
One way to think about what Munger is trying to achieve with this Circle of Competence filter is this: if you make fewer mistakes, your investment performance will be better. So invest in areas where you are competent. Why would you buy more of X which you know little about when you can buy Y (or more of Y) which is right in your Circle of Competence? The Circle of Competence approach is in part a form of opportunity costs analysis which will be discussed later in this series of posts.
The investor Li Lu describes how Charlie arrives at this approach:
“When Charlie thinks about things, he starts by inverting. To understand how to be happy in life, Charlie will study how to make life miserable; to examine how a business becomes big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. His way of thinking comes from the saying in the farmer’s philosophy: I want to know is where I’m going to die, so I will never go there.”
“The true insights a person can get in life are still very limited, so correct decision-making must necessarily be confined to your ‘Circle of Competence.’ A ‘competence’ that has no defined borders cannot be called a true competence.”
Staying within a Circle of Competence is obviously not rocket science, but it is hard to do when you meet a slick promoter who is highly skilled at telling stories. This is a case where emotional intelligence, which is very different than IQ, becomes critically important. Humans love stories since it causes them to suspend disbelief. Madoff and Ken Lay were story tellers. I put this problem in the form of a tweet recently:
“Promoters know muppets love narrative & actual facts detract from desired state of suspended disbelief. Circle of Competence…”
Munger’s advice on why staying within your Circle of Competence is important is direct as is usual:
“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.” http://www.ritholtz.com/blog/2012/02/a-lesson-on-elementary-worldly-wisdom-as-it-relates-to-investment-management-business/
It’s important to ask yourself whether you have a personality that fits with the qualities needed to make your own investment decisions that involve individual stocks bonds and other investments. Do you enjoy reading extensively about companies you may invest in and their industries? Are you going to be happy spending hours each month doing so? Or would you rather spend that time playing golf or watching sports on TV? Do you find doing the work to make yourself a wise investor is fun? Do you spend more time researching a refrigerator than the stocks you buy? Is doing due diligence on an investment the sort of thing that makes you genuinely happy. Or is it like a root canal?
“[If] you got about two inches outside the perimeter of her Circle of Competence, she didn’t even talk about it. She knew exactly what she was good at, and she had no desire to kid herself about those things.”
Overconfidence, Over-optimism and other Dysfunctional Heuristics
Why do people invest outside their Circle of Competence? The answer can be found in what Charlie calls dysfunctional “mental models” which will be discussed in detail in a later post in this series on Munger’s Methods. As a taste of that what Munger is talking about, I can’t resist inserting on quotation which describes just one dysfunctional overconfidence heuristic:
“In the 5th century B. C. Demosthenes noted that: “What a man wishes, he will believe.” And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert’s public assessment is that he is above average, no matter what is the evidence to the contrary.” http://18.104.22.168/search?q=cache:mgSaxC3O1IoJ:www.philanthropyroundtable.org/magazines/1999/march/m