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Tuesday, August 20, 2019

The Definition of Circle of Competence in the Investing World

Circle of Competence is a term used by many value investors. Warren Buffet, a successful investor wrote in his 1996 letter to Berkshire Hathaway shareholders that you don’t have to be an expert on every company, or even many. You are only required to understand few companies that are within your circle of competence. Just investing in companies you understand and feel comfortable with can create great wealth for you in the stock market or any other investment. What I mean by that, it’s better to invest in companies that you have understanding in rather than gambling your way to invest in companies that you don’t understand. This does not only apply in investing in stocks but also other investment such as real estate, and other assets. If you don’t understand how the businesses operate in a company or the investment, it’s better to stay away from it since you might actually lose money when investing in them. Understanding your circle of competence in investing helps you avoid making investing mistakes, it helps identify opportunities that you have understanding and confidence in.  So before you start investing in a stock, it is the best you really understand the companies you are going to invest in. In this article, I’m going to explain what circle of competence mean and how you can apply this term to be a better value investor.

Defining Circle of Competence
The concept of circle of competence is widely used by many value investors such as Warren Buffett himself. It’s a concept in which investors focus on only operating and investing in areas they fully understand well and have confidence in. It is a simple term to understand and I believe everybody has his own circle of competence. Each of us goes through experience or study, which eventually built up useful information on certain areas of the world. Some areas might be understood by many, while some aspect areas might require further knowledge to fully understand it. To illustrate this, those who have the basic understanding of the economics of brick and mortar retailers know how the business operates. They have to rent or buy a space, spend money to decorate the place, and hire employees to serve the customers, clean and manage the store. After that, it’s a matter if the business can generate enough traffic and making sure that the stores is able to sell its merchandise after all operating expense have been paid. Through the type of business a retailers need to face, they all have to follow the same economic formula. This gives us the basic knowledge of the business model. With some understanding of accounting and further study, an investor is able to evaluate and invest in these brick and mortar retailers whether it is a good investment or not. It’s pretty much the subject area which matches your skills and expertise.

How Warren Buffett Apply This Term Himself
To Warren, circle of competence is to understand certain industry and business that allows him to predict, with a certain degree of accuracy, how competition will turn out and translated into results in a few years ahead. Warren Buffett limits himself from investing in companies that he does not have full understanding or expertise, and only concentrating in areas in which he has the greatest familiarity. He mentions what counts for most people in investing is not by how much they know, but rather how practical they can measure what they don’t understand. What he meant by this is that it is not critical to know a bit about everything, but to know a great deal about certain topic. Most importantly is to know your boundaries when investing even when others are doing very well with their investment. Investing in only companies within his circle of competence made Warren Buffett to invest in businesses that he only have full understanding and have high conviction in. This resulted him not only become a successful investor, but wealthy as well. For example, before the dot com bubble, Warren was criticized by many for not entering the technology stocks. Warren was not able to find value in these companies and had not much understanding how the businesses even operate. He simply just stays away from investing in these companies even when others were making a large sum gain in their investment. Envy and jealousy can get you in trouble, since you see others doing well. This can result us to step out of our circle of competence just to match how others were making money. However, Warren sticks with his investing principle and stays out from investing in tech companies before the bubble burst. And the result was great. When everyone was losing money during the dot com bubble burst, Warren’s portfolio was doing just fine. Warren Buffett was so strict with only investing within his circle of competence that he wouldn’t even invest to his close friend’s company, Microsoft Corporation (Ticker: MSFT) that was found by Bill Gate. You guys probably know Bill Gates who is one of the richest people in the world. He had invented software that everyone is using. Without him, I wouldn’t even be able to use a computer to write this article right now. However, even when Bill Gates tries to persuade Warren to invest in his company, mentioning how his products can beneficial for him. He told Bill to stick with what he knows, and Warren would stick to what understand such as chewing gum and beverages companies that is within his circle of competence. For Warren to stay inside the circle of competence, he was able to obtain advantages for only investing on the area he understood the most and gained good investment results.

How to Apply Circle of Competence to Make Money in Investing?
For an investor to make money in the stock market, it’s not just about researching and monetizing on opportunities. You are required to minimize your losses. You only want to invest in stocks that you understand how the business operates and generate profit. If you don’t understand how the businesses work, it’s better to avoid it since it’s something outside your circle of competence. For instance, I don’t have an understanding in how Alphabet Inc. (Ticker: GOOG) earns their income. All I know their business provide great search engine service for people to use but have little understanding how they actually make profit from the business. Because of this reason, I stay away from investing in this company since I have no understanding and confidence how the business operate. Applying this concept make me as investor to stay away from companies that I’m unfamiliar with. It would probably make me encounter some losses if I blindly invest in one. Rule to remember, only invest in companies or assets that you understand how the business operates and generate income.

To give you readers another idea, my dad is a great example of a person who only invest in things within his circle of competence. He wouldn’t understand if someone gave him million dollar worth of Apple shares because he doesn’t even understand how a stock operates. The only thing he understands is cash, fixed income certificates of deposits (CDs), Real Estate and how to run a fan manufacturing company. Since he doesn’t understand anything about stocks, my dad doesn’t even dare to touch it as an investment or have anything to do with them. I tried many times persuading him to invest some of his savings in stocks, however he always decline my advice. So if I want to deal with my dad, I would only approach him with opportunities such as land prices or the price of the raw materials for his fan manufacturing business. He would understand the value of these things since he has familiarity in this field. If you offer him a land nearby his factory right now that is for sale under the market value, (in a snap of finger), he would probably buy it from you because he understands the value of real estates and lands around that area. It didn’t hurt my dad for not understanding how the stock market works. In fact, since he avoids investing in things he doesn’t understand made him a better investor. He avoids losses that can be lost in the stock market, and invest in things he has confidence in and most importantly understood. For instance, he understands how the fixed income CDs works in Indonesia. Realizing how the property market in Indonesia is already overpriced, he manage to stay away from investing further in real estates, and have his spare cash invested in fixed income CDs that generate him high interest rate.

I am amazed with my dad’s circle of competence in investing. I myself who was trying to challenge his investing strategy by investing my monthly savings in Indonesia Blue Chips stocks by applying value investing has returned significantly lower return performance compared to him in investing in fixed income CDs that generate a high yield. Even my brother, who is a real estate investor lost to my dad. My older brother bought rental properties apartments thinking that his investment would return a higher capital gain compared to my dad’s strong believe in Indonesia fixed income CDs yield rate. My brother’s real estate investment lost when comparing its current market value to my dad’s investing performance in the fixed rate CDs account. My dad had already warned my brother and me that the current real estate value in Indonesia is already overpriced since the year 2015, and wouldn’t increase as much as compared to have money invested in fixed rate CD account. Because of his circle of competence in investing, my dad was able to make more money just by having his money invested in the fixed rate CD account. Currently, he is making more than 8% gross from the yield the fixed income CDs rate accounts provide. It’s amazing how he was able to compound his wealth by knowing when to invest and wait patiently for the perfect time to invest. 

My dad however didn’t have his cash invested in fixed income CDs all the time. Before, he invested in a land (our current factory) in the year 2009; he had been waiting patiently and analyzing the property market since the year 2007. He had his money invested in the fixed income CDs majority of the time and having these financial instruments pay high yield for the investment principle. Before he purchased the factory my dad (currently owns now), he waited patiently for the right moment to enter the real estate investment. He told me, he had realized the land and the factory was at a bargain price when he learnt that a lot of shop houses had already increased by 50% in value from its original price. He mentioned how could a single shop house worth that much while a huge land and factory be worth lesser than that. In 2009, he immediately purchased the land and the factory even when the seller had decided to increase the price by 10% from the original listing price in 2007. He knows that the real value of the land and factory worth more than the price my dad is paying for. His investing in the real estate had inspired me, since he went in at the right time and getting a great value for the price he paid for. His investment in the land and factory nearly 10 fold (1000%) comparing the real estate market value now (July 2019) to the price he purchased in the year 2009. If my dad hadn’t purchased the land and factory in the year 2009, our whole family would have missed the property boom after that year. We would probably have to purchase the land and the factory at a price way more than the price he purchase. Not only, having the right timing in investing given my dad huge return, was he also able to utilize the factory to manufacture the electric fans in higher capacity. Since his business was still growing, he needed a land and factory that have a large space. As you can see, my dad understanding in the real estate in Indonesia and how to capitalize the fixed income CDs gave him the advantage to invest successfully. It’s because these investments are within his circle of competence, and gave him the ability to enter the investment at the right time. So remember, you don’t have to master in everything to become a successful investor. A person like my dad who has no investing knowledge in the stock market just stays away from investing in things he doesn’t understand, instead he invest in things he understands such as the real estate industry and into his manufacturing company. Similar to Warren Buffet who sticks to his investment principle, the circle of competence has made my dad become wealthy and a great real estate investor.

Expanding Our Circle of Competence
I believe expanding our circle of competence in investing gives us broader opportunity to choose, to see which one we are comfortable the most. After all, no one is born with an investment circle of competence. So how do we actually build one and expand it? Knowing your circle of competence in investing gives you the ability to understand a business you are comfortable with. Once you become competent at one or two investment that can simply generate great investment return, why should you bother trying to expanding all your other circle of competence? The two reasons I’m going to give are opportunity cost and frequency of a good investment. It is because they are eventually connected on to another. While you had already on your current spot, you will always see another opportunity that you can grab, so you can expand your ability and chances.

Opportunity Cost
Let’s say you already mastered in analyzing certain type of companies. If that is all you choose to do, you are bound to lose opportunity and forego potential high return investment. I know it’s crucial to only invest in things you fully understand and comfortable with. But on the other hand, if you had a broader circle of competence, you might have to look in other places as an investment opportunity. As I continue expand my investing experience and knowledge, I learned the important of quality, both in businesses and their management, and it makes me became more willing to pay a stock at a higher price for the quality of the company. From my investing mistakes such as purchasing a cheap stock like Game Stop Inc. (Ticker: GME), I now understand why the company is cheap for a reason. I had lost money in that investment since I was stuck in finding companies that are undervalue rather than finding quality companies that have a longer business prospects ahead. This result me to want to find great quality dividend stock companies that might be trading in fair price rather than finding poor quality high paying dividend yield companies that is trading at a discount. Warren Buffett himself claims that his worst investment was actually purchasing Berkshire Hathaway at a cheap price however knowing the company was in a deteriorating business. From this experience, he changed his investment philosophy. He mentions: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

Frequency of a good Investment
Warren Buffett has also decided to expand his circle of competence in his investing practice. He used to avoid tech companies, but he eventually changed and expands his circle of competence. Apple Inc. (Ticker: AAPL) is one of the largest tech company that designs, manufacturers and market gadgets, computer and software is actually the biggest position (23.77% weighted) that is in Berkshire Hathaway’s current portfolio (as of July, 2019). If Warren has expanded his circle of competence earlier in his investing career, he could have bought Apple Inc. stocks at a lower price when great recession of 2008 occurred. He could have made huge return if he had invested in Apple Inc. stock during that opportunistic time. This example shows that by not expanding you circle of competence; you can miss out on opportunities just like Warren Buffett did with Apple Inc. It is not simple, but it is possible to develop and grow your circle of competence. Regardless how far you want to expand your circle of competence, the most important thing you should do is to improve your thought process in general term. By doing so, you will then broaden your investment opportunity rather than having to wait in the sidelines for opportunity to come in the narrow circle of competence.

I used to believe my dad’s investing strategy is not strategic since he put his money in fixed income CDs that I believe won’t generate higher return compared to be invested in property or the stock market. However, I was able to broaden my circle of competence in investing since I learn the benefit of having liquid cash in my investing career. My dad has made me change my point of view on how to invest, and applying his strategy can be beneficial for me. It made me realized that there are many other ways to make money rather than sticking to one strategy you are comfortable with. Having me learn how my dad invests his wealth expanded my circle of competence. He made me realize the benefit of investing in other financial instruments besides the stock market. I was able to broaden my circle of competence in investing just by expanding my knowledge and understanding in investing. It’s good to stick to your circle of competence when investing, but it’s never wrong to learn and expand your knowledge and your thought process in investing. You might find opportunities that you might not have discovered if you haven’t expanded your circle of competence.

In Conclusion
Understanding the benefit to stick within your circle of competence is crucial if you want to become a great investor. Investor such as Warren Buffett has stick with his principle to generate the high return he made on his investment. Always remember that even when others are making higher return than you in investing, it’s important that you should still stick within your circle of competence. However, this does not mean you should not learn more and broaden your circle of competence in investing. You should always improve your thought process in investing so that you can seek for different opportunities out there. Sticking with what you know well and comfortable with is crucial to prevent making investing mistakes, but increasing your knowledge beyond your circle of competence is also equally important. By constantly learning, you can increase your likelihood to invest in things that are outside your circle of competence. With new knowledge and understanding, you will eventually broaden your circle of competence. But always remember that the size of circle of competence is not as important as the boundary of it. If you don’t feel comfortable expanding your circle yet, it’s best to stick inside the circle. It’s better to make better decision you are comfortable which will ultimately generate higher return on your investment in the long run.  

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