BULLS & BEARS: Investors: Stay within ‘circle of competence’

Index funds are a wise choice for many investors confronted with the overwhelming menu of investment options.

They offer a simple alternative that exposes the investor to a variety of industries at a low cost. In addition, an index fund investor’s return will exceed the net results, after fees and expenses, achieved by the majority of investment professionals, including most mutual fund and hedge fund managers.

If, however, investors choose to build their portfolio by selecting individual stocks, they should concentrate efforts on businesses they can understand and where they have the ability to reach an estimated value for the business.

This is a concept Warren Buffett has called the investor’s “circle of competence.” Buffett described this in Berkshire Hathaway’s 1996 annual letter: “Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses.”

“Note that word ‘selected,'” Buffett continued. “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.”

Sticking to businesses you understand will prevent you from falling victim to the constant rumors and hot stock tips that swirl around Wall Street. Often, investors are tempted to act on a tip. These seldom work well, then the investors are left holding shares at a loss in a business they know nothing about.

So avoid businesses or industries where you have no expertise. To be sure, there will be investments in businesses outside your circle that work out well. However, it should not bother you that these were missed because they were outside your circle of competence.

For example, our firm has not been a buyer of oil stocks, a group that has done well over the past several years. And yet we have done well by seeking out companies in other industries, where our ability to evaluate and understand the business was much higher.

Buffett was criticized during the tech mania for not buying technology stocks. In Berkshire’s 1999 annual report, near the peak of the mania, he wrote: “Our lack of tech insights, we should add, does not distress us.

“After all, there are a great many business areas in which Charlie [Munger] and I have no special capital-allocation expertise. If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the economics of companies that operate in fast-changing industries is simply far beyond our perimeter.”

Similarly, it should be a warning to investors when the management of a company strays from its circle of competence. Examples would be Coca-Cola buying Columbia Pictures in the 1980s, and Conseco in 1998 buying Green Tree, a mobile-home lender.

Thus, what works well for investors also works for businesses. Knowing the limits of your circle of competence will help you make wise investing decisions.