Understanding your circle of competence is important as it can help you make better investment decisions perhaps with an edge over other investors. A circle of competence is a mental model concept that aligns the investor’s skills, expertise, curiosity, and passion.

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What is a circle of competence?

All investors have heard of the phrase, “Circle of Competence” (if you are new to investing you are forgiven). When I first heard of this term, I immediately gravitated to it. I thought I could discover my “edge” and become a better investor in the areas I knew well and in the industries in which I had been building businesses. However, I was wrong. I still lacked competence in many areas such as what makes a company more valuable than another one. Equally important how do we analyse that value?

“You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence. The size of that circle is not very important; however, knowing its boundaries is vital.”

Charlie Munger

The circle of competence is quite a simple idea, everyone has a certain level of knowledge through experiences, work life, entrepreneurial activities, and study. Certain areas make a lot more sense to us than others. What can be confusing to another investor can make complete sense to us and vice versa.

The circle of competence visual is made up of the 3 components. The small red circle is what we know, the information and confidence in our knowledge and expertise. The circle outside of that is the most dangerous place, what we THINK we know. This is the area where a lot of investors play. They think and assume they know more than they do, often leading to mistakes and lost capital. Then there is the larger circle which is everything we don’t know.

Misconceptions about what “competence” means.

I think the competence meaning can be taken out of context as many investors say, “I don’t have expertise in any industry”. Whilst having knowledge in a certain industry and the experience built up from your career, studies or building businesses is helpful, it still leaves a gap in what competence means. More importantly, how can it be applied?

Where I believe investors go wrong is assuming that industry experience and knowledge are all that is required. You can still know a lot about a topic or industry but if you cannot understand and analyse that business from an investment perspective, you can’t leverage that knowledge.

How many investors have a position in the FAANG stocks yet have no idea how phones are made, how electric vehicles are manufactured, no knowledge about semi-conductor materials or how e-commerce global operations work? By simply following the definition of “Circle of Competence” there may not be much investing at all.

These misconceptions can cause investors to steer away from good opportunities simply because it does not immediately fall within their competence. Someone can still have no competence even though they have industry experience and knowledge. How will they assess value? Is it a good business? Is it financially healthy? What does the 3 financial statements say about the company?

Investors can still do very well without having a deep underlying understanding of a company or sector. This is where I believe the Circle of CONFIDENCE can be used to help close this misunderstanding about competence.

It’s not necessarily about specialisation – it is about confidence. What are you confidently able to assess and analyse?

How to define your circle of competence?

Everyone has this built-up useful knowledge. It’s not only about focusing on your strengths but about being honest with your weaknesses. Invert the idea and ask…

“What don’t I know?”

This helps us to work backwards, not simply laying out the industries you know, what you know about business, and perhaps your fundamental analysis capabilities. The most important first step in defining your circle of competence is honesty and humility with yourself. Overconfidence is the biggest mistake investors make.

Your circle of competence is going to be a lot smaller than you realise at first. You need to refine not only what you are curious and passionate about but also what you are comfortable assessing. If you must ask, “Am I capable of understanding this?” it probably is not within your circle.

Once you have outlined where your strengths and weak points are, that ends up narrowing down a lot of the areas where you will end up avoiding and as a result where to apply focus.

For example, if we look at the below table and tick each of the categories and where we align the most, they help to define the playing field.

Industry	Career / Experience	Education / Study	Passion + Curious
Utilities
Real Estate	✅	✅	✅
Materials
Mining
Consumer Discretionary	✅		✅
Consumer Staples
IT + SaaS		✅	✅
Financials
Retail	✅	✅	✅
Communications
E-Commerce	✅	✅	✅
Energy

Once you have a general idea of the areas that form your competence you can refine it even more by considering your confidence about analysing a business. Passion and curiosity are very important aspects to consider. This is because you are far more likely to dive deeper into researching and learning the areas that align with what you want to learn.

Questions to consider:

• What do you know a lot about? Could be an industry, experience, education?
• What are you passionate and curious about? What don’t you mind learning or researching?
• Are you comfortable assessing a business? Can you read financial statements? Ratios?
• Can you identify competitive advantages, what makes this company better than the rest?

3 Key areas that can make up your competence.

The 3 key areas below show what I believe can help investors form a winning circle of competence. The circle that shows industry experience is what we discussed above in the chart. Depicting the areas you know, studied or are passionate about developing a greater understanding of.

Then the circle showing behavioural edge is about being honest with yourself, and what you can assess and understand. Finally, analytical expertise is about your investing knowledge and experience, what you can analyse, value, and interpret from financial statements.

You may have industry expertise in say retail from working in the retail sector, but you may lack the analytical capabilities to assess the business model. Things such as inventory turnover, accounts receivables, and working capital evaluations. Being honest that you may know what the business does but not necessarily how it makes money and whether it is financially stable is where honesty with yourself comes in.

You need to focus on the businesses and ensure you understand them from the outside down to the core. How does the business make money? What drives its growth? How does it make a profit? Is it a top dog or under threat? What is the future outlook? Is it financially healthy? Is it expensive? What do I think the company could be in 10+ years?

Investors that do well are usually focused right on the centre of that sphere. They know the industry, and the analysis capabilities to make sound fundamental decisions in combination with the behavioural attributes to back it up. That is the sweet spot.

Slowly expand your circle of competence over time.

There are two ways to implement the circle of competence with every investment opportunity that comes your. If you understand the business to some degree then great, proceed. However, if you get an opportunity you are not familiar with, you have only two options. 1) Pass on it, let it go and move on or 2) Learn about it and in the process expand that circle of competence wider.

Every investor can expand their circle of competence over time. They can learn how to analyse better, study financial statements, and work on fundamental analysis, and quantitative and qualitative processes. Investors can study thematic themes intently learning about the future or industry classes.

You can develop competence around MOATs and how to identify a company with a competitive advantage. Perhaps understanding and studying network effects and inflection points is what you are curious about. By studying these unique areas, you may be better equipped to see these qualities in companies.

The point is industry and experience are one part of the equation. By passionately pursuing areas that pique your curiosity you develop a wider knowledge base in certain areas. Over time knowledge compounds. Investors develop these specialised areas that they are very confident in. They developed it over the years, not all at once.

I come across companies and certain industries that are not immediately within my circle of competence, I may be confident in analysing the business, but I still pass. Then on other occasions, I may not know much about an industry, but it is something I’m passionate about and hungry to learn. So, I dive in, learn as much as I can to then develop the confidence to invest.

You need to look at every business and study it deeply like you know nothing about it.

In Summary…

The circle of competence is an important mental model to consider. It is not about being over the top either, otherwise there may be nothing left to invest in. The confidence to learn and apply that knowledge is equally important.

This is the basis of how I approach most of my investment ideas. Do I know anything? Do I want to know anything? Am I willing to spend the time to know something?

This approach blocks out a very large part of the market so I can remain very focused on the opportunities I believe will give me the best results.

A simple checklist to ensure you are always navigating within your circle of competence:

1. Play to the strengths that you already have developed.
2. Identify your weak areas and remember overconfidence bias – avoid it.
3. Define your passions and curiosity to identify areas to learn.
4. If you have the desire and patience to learn about something new…do it.
5. Learn how to analyse, read, and study a company intently.
6. Lifelong learning is about continuously evolving.

Identifying and acting from your circle of competence involves acting from a place of confidence and humility. It can lead to better investment outcomes by simply honing down and avoiding areas that can lead to poor results. Staying within your circle of competence does not guarantee you will hit winners, but it is still a better approach than investing all your time and capital in a business you have no idea about.

That seems like a pretty good way to minimise risk.