Lesson 5: The Circle of Competence
Value Investing 101: introductory course
As an investor, you’re constantly faced with new opportunities and challenges. There are thousands of stocks to choose from, spread across dozens of sectors and markets. But how do you decide where to invest?
One of the most underrated yet crucial concepts in investing is the Circle of Competence—knowing what you truly understand and what you should stay away from.
Warren Buffett put it this way in his 1996 letter to shareholders:
"Intelligent investing is not complex, but that’s far from saying it’s easy. What an investor needs is the ability to correctly evaluate certain businesses.
Take note of the word 'certain': You don’t need to be an expert on every business, or even many. You only need to evaluate the ones within your Circle of Competence. The size of that circle isn’t important; knowing its boundaries is essential.
Your goal as an investor should simply be to buy a part of an easy-to-understand business at a reasonable price, one whose revenue and profits are virtually certain to be higher in five, ten, and twenty years."
In other words: You don’t have to understand everything, but you do need to know what you understand.
Let’s dive deeper into this concept and see how you can apply it to your investment strategy.
What Is the Circle of Competence?
Your Circle of Competence is the area where you have enough knowledge and experience to truly understand a company. This doesn’t just mean knowing what a business does, but also:
How it makes money.
Who its competitors are.
The risks and opportunities within its sector.
Outside this circle, you’re on dangerous ground. That’s where decisions are based on half-baked knowledge, emotions, or blind trust in someone else’s analysis—a recipe for poor returns.
Charlie Munger once said:
“Warren and I only look at sectors and businesses where we have core competencies. Everyone should do the same. You have limited time and talent, and you must allocate them wisely.”
In other words: Specialization is a strength.
Why Is This So Important?
Many investors get excited about companies in sectors they barely understand. Think about:
Biotech companies with complex drug pipelines.
Banks and insurers with opaque balance sheets.
Tech firms whose products are hard to grasp.
People often buy stocks simply because they believe the sector is “the future.” But if you don’t understand how a company makes money, how will you judge whether it’s a good investment?
The stock market rewards patience, knowledge, and rational decisions. But if you invest in something you don’t understand, you’re playing with fire.
How Do You Define Your Circle of Competence?
The first step is accepting that you don’t need to know everything. Instead of chasing “the next big trend,” focus on companies and sectors you do understand.
Here are a few questions to help define your Circle of Competence:
Do you understand how the company makes money?
Do you know its key competitors and market trends?
Do you grasp the risks and challenges in this sector?
Could you explain the company in simple terms to someone else?
If you answered no to any of these, you’re likely outside your Circle of Competence.
Or, take Charlie Munger’s approach: Define your Circle of Competence by identifying what you don’t know.
Munger often said:
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
Or, to put it another way:
"You don’t need to be great at everything. In the Olympics, if you’re good at the 100-meter sprint, you don’t need to be a shot putter.”
This doesn’t mean you can’t learn new things. In fact, the goal is to expand your Circle of Competence. But it does mean that you should only invest in businesses you understand at the time of your investment.
Real-World Examples
Example 1: Warren Buffett and Tech Stocks
For years, Buffett avoided tech stocks—not because they lacked potential, but because he didn’t feel competent enough to value them properly. He only invested in Apple once he truly understood the company and it became a household name.
Example 2: Peter Lynch and Everyday Businesses
Peter Lynch, one of the most successful fund managers, advised investors to invest in businesses they encounter daily. Think of supermarket chains where you shop or clothing brands you wear.
"Invest in what you know. The biggest winners are often the companies right in front of you."
Example 3: The Dangers of Hype Investing
Many people invested in cryptocurrencies and NFTs without understanding how they actually worked. Many lost money simply because "everyone was doing it."
Key Takeaways
You don’t need to understand everything.
The best investments are the ones you truly understand.
Avoid complex sectors where you don’t feel comfortable.
How to Expand Your Circle of Competence
Read a lot. Learn a lot.
Most people want to get rich quickly, but that’s not how it works. Expanding your knowledge is a gradual process—by reading, reading, and reading some more.
As Munger put it:
"You don’t need to pee on an electric fence to learn not to do it."
He also said:
"Learning from other people’s mistakes is much more pleasant. The best way to do that? Simple: If in doubt, read so you can learn vicariously."
Munger loved emphasizing the importance of reading:
"In my whole life, I have never known a wise person (across a broad range of subjects) who didn’t read all the time—none, zero. You’d be amazed at how much Warren reads, and how much I read. My kids joke that I’m just a book with legs."
So, read a lot. I have yet to meet a successful investor who doesn’t. Lifelong self-education through vicarious learning is key.
That’s the only way to expand your Circle of Competence.
Even if you’re not an expert in anything, there are topics you know better than others. Start by refining those areas to your advantage. And yes—reading will help with that, too.
Conclusion & Homework
The Circle of Competence is one of the most powerful concepts in value investing. It protects you from foolish mistakes and helps you make rational decisions.
Homework:
Make a list of sectors and companies you understand well.
Note which sectors interest you but where your knowledge is still lacking.
Read an annual report from a company inside your Circle of Competence and one from a company outside it. Compare your level of understanding.
If you know your limits, you also know where you can operate safely. As Buffett emphasized:
"It’s not a problem if your Circle of Competence is small—as long as you know where the edge is."
Investing isn’t about knowing everything—it’s about knowing where your strengths lie and making the most of them.
Know someone who’s always chasing the latest hype? Send them this lesson.
The start:
