This doesn’t mean that you should narrow your lens and only bother about what goes on in your own world. It is absolutely important to stay within your circle but there is no rule restricting you from expanding this circle. The idea is that you should have a firm understanding of the opportunity you have researched on before investing. That would minimally include understanding the business model, management’s ability and macro-economic factors at play.
Warren Buffett has only been investing in companies with business models he understands. These are household names that many of us are aware of – Kraft Heinz, McDonald’s and Coca-cola to list a few. While these are the typical boring stocks, they have compounded his wealth exponentially.
He has never jumped on the bandwagon and invested in the hottest stocks. He stuck to his circle of competence and never left it.
Why stay within your circle of competence?
Acquiring an advantage over the rest
To perform well in the market, you don’t have to be amazing like Warren Buffett or Seth Klarman. You just need to be better than the rest. This isn’t just about being smart and analyzing the right information, you have to acquire greater emotional discipline and fortitude than others too.
By being an expert in the field you are investing in, you will also acquire more confidence to develop your emotional intelligence too. As your research gets more advanced, you will develop a keen eye for identifying safe and undervalued stocks.
Over time, you will tilt the odds of winning heavily in your favor.
Regardless of what others say, humans are not designed to multi-task. Multi-tasking isn’t just about watching a movie, having dinner and talking all at the same time. We are talking about performing multiple high performing tasks at the same time and research has shown that this is not possible.
Research has shown that in order to perform your tasks to the best of your abilities, which you should, you will require maximal concentration on your task at hand. This is extremely crucial when you are researching on your next investment idea.
Without focusing on your circle of competence, you will be distracted by noises that you don’t understand. You will be likely to be lost and aimless in your analysis. Without the circle of competence as a starting point, you will have tens of thousands of companies to work with.
Knowing what you are good at and are comfortable with, you can quickly identify and work with a manageable number of quality and undervalued stocks.
Value investing is about making more right bets than erroneous ones. That said, making mistakes is part and parcel of this operation. By sticking to what you are good at, you increase the overall likelihood of making the right bets.
After gaining all the knowledge over the years, you will develop the mental resilience to overcome most psychological influences emanating from the market. If you know what you are doing, you are sensitive to identifying the market’s overreactions to events that have no lasting impact.
For instance, when Donald Trump was appointed as the 45th President of the United States, the stocks plunged momentarily. There was no change in fundamentals and economics at all. It was solely due to an increase in uncertainty in the mid-term that led to such a reaction.
Of course, the market soon realized its folly and corrected itself.
If you think and act rationally and know that your holdings will be affected minimally, there is no reason for you to panic with the market.
Expanding and strengthening your circle
After identifying your circle of competence, you should seek to improve and adapt to market changes.
Needless to say, expanding your circle of competence increases the number of opportunities you can find. It provides you with a more complete picture of the industry and the companies you are considering.
Strengthening your circle of competence, on the other hand, increases the quality of opportunities you can find. Value investing is a never-ending journey of improvement and learning. Never rest on your laurels and think that you have already beat the game of investing, especially when your ‘superior’ results only span over a few months.
Identify, expand and strengthen!