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The Circle of Competence Trap
Balancing prudence with "militant diligence"
I am going to start this piece off with a hypothetical situation and propose two paths to you, dear reader. Which will you take? Which feels more risky? Which is more comfortable? Let’s say a friend/co-worker/boss approaches you with a stock he or she thinks you seriously consider for investment. You have no experience with this company or its industry. In fact, the company exists within a niche that is dominated by analysts and PMs who are specialists, many of whom have degrees and a fluency that you do not possess. What is your response?
A) No way! This company is totally outside of my circle of competence. Even if I try to do the work, I will undoubtedly be the pasty at the poker table and I have no business competing with the experts in this space.
B) Sure! I can tackle anything. It is just about effort and time and I have enough experience to have success investing in this very specialized industry, regardless of the sophistication of my “competition”.
I think both responses are right and wrong at the same time, with the key variable being time horizon.
Static vs. dynamic mindset
Anyone who has listened to enough interviews with Buffett and Munger, or has been to the Berkshire annual meeting, has inevitably been introduced to the topic of circle of competence. What is this mysterious thing? It is a metaphorical circle that captures all of the areas in which you have some level of expertise as an investor. The companies and industries you know very well sit squarely in the circle, while those you have less or no history with sit on the outside. The idea that emanates from Omaha is that it is prudent to stay within your circle of competence when you are approaching a new investment. Never looked at a regional bank before? Probably best to stay away. Don’t have a PhD of any sort? Better to avoid investing in biotechs. The investors who focus on these areas have a distinct advantage relative to someone approaching these specialized industries for the first time.
I think this is generally pretty good advice but, for it to be really helpful, it requires a more dynamic addendum. Refusing to dive into a new industry because you have no experience is a very static way of looking at your own skill set. What you ideally want as an investor is to continuously build your circle of competence so that it includes more and more areas where you are no longer a novice. Younger readers will have no idea what I am referencing, but think of your circle of competence like the blob from the 1958 horror film. It just keeps expanding and expanding until there are no industries left to conquer. That is representative of a dynamic mindset. But does everyone interpret the idea of the circle of competence that way? I don’t believe so, mainly because I myself have used my circle of competence as an excuse to not delve into areas outside of my comfort zone. If you aren’t really focused on your evolution as an investor or if you aren’t paying attention to the examples Buffett and Munger have provided, falling back on a circle of competence can lead to stasis, even laziness.
An alternative is militant diligence
I am certainly not going to be the first person to link to the very-much-worth-listening-to Art of Investing interview with Berkshire’s Todd Combs. Lots of people have praised it to the sky on social media. There were plenty of great stories and anecdotes but the thing that really stuck with me is the phrase “militant diligence.”
I ended up working with Blue Ridge Capital and Pete Daneker was their FIG specialist. He went to Princeton and he was a Morgan Stanley banking analyst for a couple of years, he became a real mentor of mine. Just a truly, truly phenomenal person who took so much time with me. It was a complete one-way door.
I was getting everything from Pete, giving basically nothing back after the stat blanks, they could have just ditched me on the side of the road, which is probably maybe what I would have done. But no, they took me under their wing and then that led again one thing after another after another.
And then I graduated Columbia in '02, and they literally said, here are five places that need a FIG person. So I knew at that point from my regulatory days, I knew banking and I knew insurance. I didn't know specialty finance, so then I went and took -- there's a whole specialty finance series of courses at NYU at the time, which I took at nights and on weekends to get the certificate to be able to tear apart credit card securitization so you could literally do it.
The course was really built for people who are going to work in an investment bank actually doing these things, but I wanted to be able to do it as an investor, and they couldn't believe it. And I was the only person that was an investor there, and I was like, I can't believe all these investors aren't in this course. So there's just that militant diligence is what I would call it.
Todd Combs knew insurance really, really well from his days of being Florida state insurance regulator. But he didn’t know anything about specialty finance or how to analyze securitizations. What he had was a deep curiosity and drive to expand his circle of competence. He didn’t use his lack of experience as an excuse. He even went to night school to learn about a new industry. This is a pattern that is consistent among some of the best investors. They expand their circle of competence, sometimes voraciously and sometimes more methodically, over a number of years. My point is that they are intentional about it. They don’t fall into the “this isn’t in my current circle of competence” trap.
Understanding the circumstances in which you can be successful
The Todd Combs example highlights the importance of developing expertise, and recognizing when you have an edge over other people. Edge is a fuzzy concept in the public equity investing realm. It is hard to define and it is even harder to provide tangible support to the idea that a person or firm has an edge. And even if you do have an analytical or informational edge, all kinds of lucky and unlucky things can happen that influence the success of an investment. I would argue that developing an edge regarding the stocks you own is helpful but certainly not sufficient to lead to outperformance. On the other hand, investing when you clearly don’t have an edge or the experience, pattern recognition and knowledge base can be a mistake. Sure, you might get a few right but the odds are against you. Repeatability is what clients are looking for and eventually investing outside of your circle of competence will detract from returns, at best, or lead to disaster, at worst.
With all of the preceding comments as context, let’s return the scenario I presented at the beginning. In answering the question, I would choose A and B, just with varying timeframes. The first answer is A. I recognize that, if given a nudge to do the work on a specific biotech company, I will be veering outside of my current circle of competence. I know there are PhDs and other experts in the field who have models that predict the outcome of clinical trials that I cannot compete with—at least not right now. That leads me to choice B. If I extend the timeframe and move from the specific—a single security—to the broader context—an industry I have yet to spend the requisite time researching to feel comfortable investing in—that eliminates what is in reality a false binary choice. B is a path only after A has been chosen. That process takes time. In the case of me and biotech, probably a lot of time. Other industries would probably take far less time for my circle of competence blob to consume. But it takes militant diligence or simply being intentional—and patient.
Shane Parrish of The Knowledge Project talks a lot about positioning yourself for success. My humble suggestion is to know if you are positioned to be successful as you approach a new investment. Specifically, consider whether a security or industry fits within your circle of competence, or not. Be intellectually honest about it. If the answer is or no or even maybe, be willing to pass. Your odds of success are higher if you stick to what you know and understand. But you can’t stop there. Evolution is a must for survival in the investing game. The willingness to take the time to slowly and methodically expand the number of companies you feel comfortable analyzing is a good way to distinguish yourself as an investor. And if you need inspiration, look at 99-year-old Charlie Munger. I don’t think 65-year-old Charlie would have been comfortable investing in BYD. For that matter, 65-year-old Buffett probably never puts a dime into Apple. Just thinking about the examples they have set by expanding their circle of competences over time—and how that has compounded their knowledge—is evidence that you shouldn’t take their advice to not invest in things you aren’t familiar with as some sort of gospel. In fact, there is a temporal element that is missing and that nuance is missed by a lot of investors, including me, at times.
Preparing to start building my circle of competence at a rapid rate,