Warren Buffett & the Circle of Competence
You don’t have to be an expert on every stock to find great businesses trading at fair or better prices.
The less complicated an investment is, the less room for error in your analysis. Similarly, sticking to investing in businesses you understand will is critical to minimizing investing mistakes.
Warren Buffett calls sticking with what you know staying in your “circle of competence”.
“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
Warren Buffett says knowing the boundaries of your circle of competence is far more important than having a large circle of competence.
“What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”
Knowing what you don’t know runs contrary to human nature. Most people don’t like admitting their own ignorance – even to themselves.
Everyone knows at least one ‘know-it-all’. If you want to invest well, don’t be a know-it-all.
“There is nothing wrong with a ‘know nothing’ investor who realizes it. The problem is when you are a ‘know nothing’ investor but you think you know something.”
If you know you don’t know much about investing, don’t fool yourself. Instead, invest in the world’s best dividend paying businesses through high quality dividend ETFs.
Warren Buffett’s IQ is estimated to be between 130 and 160. He is incredibly smart. But genius is not a requirement to realize exceptional investing results.
“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”
Knowing the limits of your circle of competence is more important than being brilliant and thinking your circle of competence includes all stocks. There’s no mistaking Buffett’s business genius. Even he does not think he can accurately assess all businesses.
“We make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge.”
Don’t try to be smarter than Buffett. You aren’t – and that’s okay. Neither am I. Neither is nearly every other investor. Instead of taking unnecessary risks, invest in great businesses you understand when they go on sale. It doesn’t take a rocket scientist to invest in this manner.
4 Buffett Quotes on Great Businesses & Competitive Advantages
Investors can be divided into two broad categories:
– Bottom up investors
– Top down investors
Top down investors look for rapidly growing industries or macroeconomic trends. They then try to find good investments that will capitalize on these trends.
Bottom up investors do they exact opposite. They look for individual investment opportunities irrespective of industry or macroeconomic trends.
Warren Buffett wants to invest in great businesses. He is a bottom up investor.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
Buffett prefers to invest in businesses that have differentiated themselves from the competition. Commodity selling businesses don’t have a differentiat or (unless they are the low cost producer).
“Stocks of companies selling commodity-like products should come with a warning label: ‘Competition may prove hazardous to human wealth.’”
Commodity business (in general) are not quality businesses for long-term investors. The reasons is because competition will erode margins and make investing in the business a zero-sum game.
Commodity businesses that have found a way to survive are not great businesses. The analogy below emphasizes this point:
“A horse that can count to ten is a remarkable horse—not a remarkable mathematician.”
Don’t invest in horses that can count to 10. Invest in businesses with a strong competitive advantage that allows for large excess profits…
And make sure that company’s competitive advantage is durable.
“Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me.”
