March 13, 2013

The Circle of Competence

The “Circle of Competence” is an investing concept coined by Warren Buffet and Charlie Munger. The former once remarked in one of his now legendary shareholder letters that “One of the things we try very hard to do at Berkshire, is to stay within what I call our circle of competence.” What that meant for Buffet was sticking to “simple, understandable businesses”, usually with what he called a “wide moat” or  some “durable competitive advantage”. This was why Buffet and Munger took a pass on the entire .com bubble. While they were decried for being “out of touch” and “not with it” anymore, they not only sidestepped the entire .COM bubble popping, they also did ok in the interim (understatement) by sticking to what they knew best.

Now “simple, understandable businesses” may be Buffet and Munger’s circle, that circle can be, and is, unique to everybody. Your task is to find yours and refine it, cultivate it.

It is important to understand that one man’s circle is another man’s unfathomable hall of mirrors. So while Buffet took a pass on the .COM era simply because he didn’t understand computers, there are others who have read and memorized every version and fork of the linux kernel source code. Buffet’s partner Charlie Munger once told this interesting parable about the circle at a Westco shareholder meeting:

He mentioned a friend of his, John Ariaga. John, over the last 30 years, has only invested all his money in commercial real estate within four to five blocks of Stanford University. He made no other investments over that period. Munger was saying he was worth between 400-500 million today.
In the mid- 90s, he got goosy about real estate, and leverage and he significantly delevered all his properties. When the dot com boom came in ’98 and ’99, all his real estate went through the roof. Then a year to 18 months later, occupancy was at 60%. There were a large number of foreclosures all around Stanford and at that point he levered up and he bought all the real estate.

The point that I took home from that discourse Munger gave was that to get very wealthy you don’t need a large circle of competence. In the case of John, he probably got approached in the last 30 years to put money in Chine, to put money in oil, to put money in stock, to put money in India, whatever. All his rich friends telling him what to do and he probably rejected all of them and he didn’t ever go 10 blocks from Stanford. He stayed very close. John’s circle of competence is extremely small, but he’s wealthier than most of us in this room.

(emphasis added)

The point of all this is to say that you have to find “your own personal Circle”, and please know that this is not “doing what you love”. You should read MJ Demarco’s Millionaire Fastlane for more on that (I will review that book in another post, great read). To succeed in this life you need an edge and it’s within that Circle where you will find it.

What this means is that if you’re an out of work janitor who loves goldfish, you have a better shot at becoming wealthy by starting a cleaning supply company than you will building koi ponds. This is because you know more about cleaning, cleaning supplies, what works and what doesn’t, than 99% of the population. And that folks, is what’s called an edge.

The Circle of Competence


But Out Here (outside the circle):

  • You’re an amateur
  • You have no edge
  • Everybody else makes it look easy
  • You’re going to get your head handed to you.

Outside the Circle, people are prone to what I frequently call dreaming instead of doing – getting more caught up in the romance and “glamour” of ostensibly making yourself rich, but instead you are more often heading down the road to ruin while simultaneously enriching some self-professed “guru” who’s sending you there.

I call the four most pernicious routes to this type of self-destruction “The Four Horsemen of the B.Y.O.B (Be Your Own Boss) Apocalypse” as follows:

  1. Flipping Houses / Real Estate
  2. Daytrading, Forex
  3. MLM the newest, hottest “thing”
  4. Professional Blogger / Internet Marketer

What is common on all four routes is from the outside looking in, it seems like everybody else is making easy money with little effort, and you feel left out and wanting to “join the crowd” and get rich like they are. All of which is purely illusory.

Granted, nobody is born an expert at anything. Everything is learn-able, and we all have to start at square 0 in whatever calling we choose. But at a certain point, you’re no longer a kid and you’ve accumulated some kind of life experience that amounts to proficiency in something. Even if you’re not an outright expert at anything, there’s some things you know more than anything else and you have to look at sharpening those into your personal edge.

A good example of this we go back to the aforementioned MJ Demarco. He drove a limo for a living but he loved Lamborghini’s, how did he make his fortune? He didn’t set out to “do what he loved” and attempt to become the number #1 Lamborghini test driver on the circuit. He took what he knew and ran with it.

As I mentioned, I will be posting a separate review on the Millionaire Fastlane (despite the hokey title, a must-read book).