Thinking tools
Circle of competence
Know where your real understanding ends, and keep your big bets inside that line.
Warren Buffett, 1996 letter to Berkshire Hathaway shareholders.
Buffett told shareholders that an investor only needs to evaluate companies within their circle of competence. He added: "The size of that circle is not very important; knowing its boundaries, however, is vital." The circle is the set of things you understand well enough to predict, including how they fail. Most people have a few areas like this, built from years of close contact.
It works because errors cost more outside the circle and you are least able to see them there. Inside it, you can tell a good argument from a confident one. Outside it, you cannot, so you fall back on what others say, which means you are betting on their judgement without knowing it.
The circle is not fixed. You can widen it through deliberate study, small bets and honest feedback. The common misuse is treating it as an excuse never to learn anything new. Another is assuming that expertise in one field transfers to a neighbouring one that only looks similar.
Example
In 1999, at the height of the dot-com boom, Berkshire Hathaway's per-share book value rose just 0.5%, which Buffett called the company's worst performance relative to the Standard & Poor's (S&P) 500 index. In that year's letter he explained why Berkshire owned no technology stocks: "we have no insights into which participants in the tech field possess a truly durable competitive advantage." He stayed out, and avoided the losses when the bubble burst over the following years.
Where it applies
Before you take ownership of a decision in an unfamiliar area, such as security, pricing or a new framework, say plainly whether it is inside your circle. If it is not, find someone for whom it is, or make the bet small enough to learn from.
Think about it
Which decision on your plate right now sits outside what you actually understand, and who could you ask?
Applied it to something real? Log it.
Test yourselfAccording to Buffett, what matters more: the size of your circle of competence, or knowing its edges?
Knowing its edges. A small circle is fine as long as you know where it ends and keep big bets inside it.
Related models
- The map is not the territoryEvery model, metric or plan is a simplification, and the parts it leaves out can matter more than the parts it shows.
- One-way and two-way doorsMake reversible decisions quickly and save slow, careful deliberation for the ones you cannot undo.
- The Feynman techniqueTest whether you understand something by trying to explain it in plain words to a beginner; where the explanation breaks, your understanding has a gap.
- Margin of safetyLeave a wide gap between what you expect to need and what you build or pay, so that your errors and bad luck do not sink you.
- Comparative advantageEven if you are worse at everything, you gain by doing what you are relatively least bad at and trading for the rest.