In this article, I will discuss the importance of Warren Buffett's circle of competence for investors. I will also explain how you can identify its boundaries, how you can expand your circle of competence, and how value investors can use this information to make smarter investment decisions.

Put simply, the "circle of competence," a term coined by Warren Buffett, just means to invest in what you understand. However straightforward this may be, many institutional and individual investors invest in assets they do not understand, which is why this concept is important to discuss.

The Circle of Competence

This term was first coined by Warren Buffett in his 1996 Letter to the Shareholders:

"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 | 1996 Letter to the Shareholders

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In short, what Buffett is discussing here is the importance of understanding a business before investing in it. In other words, if you're going to invest in a business, you must have a thorough understanding on how the company makes money, how it spends its money, and what factors impact its operation in its industry.

Moreover, the size of your circle of competence is not important. Instead, what's important is knowing your circle's boundaries and trying your best to never cross these boundaries. Therefore, you should know what companies you're capable of understanding and which ones you cannot understand.

The Three Circles

These three circles, as illustrated below, help to explain the circle of competence:

Outer Circle

The outermost circle describes the companies that you have absolutely no understanding in whatsoever.

Obviously, you would never invest in these companies until you thoroughly understand the company and the industry it's in. For instance, many people have no idea on how most pharmaceutical, energy, or genomics companies operate, and therefore do not invest seriously in these companies.

Middle Circle

The middle circle describes the companies that you think you understand, when you actually don't.

This circle is where most people get into trouble. Just because you read an article and/or heard about the company on the news or from a friend, does not mean you understand the company.

Moreover, you don't have a good understanding of a company and its industry from analyzing its financials or from trying to value the company. To begin, these are all things that should generally be done after understanding a company and its industry. In addition, a company's financial performance or financial ratios tells you nothing about how the products/services the company produces are made, how competent the management team is, any competitors, what the industry outlook is, etc.

Therefore, even if a company I'm analyzing has great financials and forecast growth, I would still hesitate to invest in the business if I could not understand the company and its industry thoroughly.

In short, to be a successful value investor over the long-term, try your best to eliminate investing in this middle circle. Although you can profit from investing in assets that are outside of your circle of competence, doing so is a lot more difficult to do consistently.

Inner Circle

The inner circle is your circle of competence, which includes the companies that you are capable of understanding thoroughly.

Again, the size of your circle of competence doesn't matter too much, although increasing the size is never a bad idea as it could lead to more investment opportunities. In general, the older you are, the bigger your circle of competence.

An industry example of most people's circle of competence are restaurants, which in most cases, are just up-scale lemonade stands. I'd assume that most people understand the costs associated with running a restaurant and how it generates revenue.

How to Invest Within Your Circle of Competence

To invest within your circle of competence, simply invest in companies or industries that you're very familiar with.

Although this may be rather intuitive, to understand what your personal circle of competence is, you can look at your job/career, your hobbies, and products/services you regularly buy. For example, if you're a pharmacist, you'll likely be able to explain how the pharmaceutical industry operates and what drives revenues and expenses in pharmaceutical companies. Most of all, you'd be able to explain it to anyone who asks.

Important questions you can ask to determine whether you fully understand a company or not include:

• What products/services does the company sell? To what market? What makes them profitable?
• What's driving the company's growth?
• How competent is the company's management team?
• How does the company stand against its competitors?
• How does the company manage its costs?
• How does the company's industry operate?
• What are the related risk to investing in the company?

If you can answer these questions, then at the very least you're in the middle circle, where you think you know but actually don't. To be considered within your circle of competence, it's likely that an even closer look into the business and its operations will be required, as later discussed. Many of these questions can also be answered by reading through the company's 10-K annual reports.

How to Grow Your Circle of Competence

In general, the best companies to invest in over the long-term for beginners are companies with relatively simple business models, as you can learn a lot about them and quickly grasp how their business operates. These companies are simple in nature, which makes them easy to run even with a bad management team. One example of this is Netflix (NFLX), which has a rather simple but effective business model.

If you want to grow your circle of competence or have a stronger circle of competence, there are many approaches you can take. There is no right or wrong way of going about it, as long as you feel that you have a thorough understanding of the industry and the company by the end of your research.

One approach to begin understanding a company/industry, is to spend time researching one signature product/service the company offers. Truly understand this product/service, its competitors, and its competitive advantage. Naturally, you will learn more about the industry, the company, and how profitable other products/services in the industry are, thereby expanding your circle of competence.

It may also be in your best interest to spend time researching companies that have a good value set that is connected to yours. In this case, you may be driven to understand them even more than the average investor.

Research Example: Small Banks

If I wanted to invest in small banks, a small segment in the massive financial services industry that is likely a lot less complicated than big U.S. banks like Bank of America (BAC), The Goldman Sachs Group (GS), and Wells Fargo & Company (WFC), I would follow the approach below:

• Read the most recent 10-K annual reports: I would focus on the biggest players in the small banking industry. This will give you an idea on what "normal" looks like, what small banks are over-performing and why, all the revenue streams and divisions of small banks, and what small banks are doing now to grow in the future, among many other things.
• Subscribe to industry publications: Although this may cost you, this can provide you with an insider look from analysts or individuals who know a lot more than you on the small banking industry.
• Listen to earnings calls: If you listen to company earnings calls, read the transcripts, or read the earnings reports (which are all open to the public), you will have a better grasp on where the company and small banking industry is headed and what challenges they're currently facing.
• Follow authors that discuss small banks: These authors may provide you with new information that you can look into further, or at the very least, provide a fresh perspective on the small banking industry.
• Read shareholder letters: If you read shareholder letters over the past 5+ years for multiple small banks, you will learn a lot about problems and/or challenges within the business, how the CEO discusses the company and its stock price, and other management-related insights.

I know little about small banks, but if I were to follow this approach overtime, whether it be a few weeks or months, I'd likely be able to consider many small bank companies and the industry within my circle of competence. In general, this approach can also be applied to other industries and companies as well.

If, for whatever reason, I could not understand the small banking industry and how companies within the industry operate, then I'd just move onto the next company or industry. Granted, this does not mean that you can never invest in the company or industry, but it may mean that as of now you shouldn't. Instead, focus your time on something else or come back to it later after you've done more research.

The Bottom Line

Warren Buffet's "circle of competence" term simply means to invest in companies and industries you thoroughly understand.

Often times, the circle of competence is overlooked because investors are overconfident in their ability to make money in any company or industry, regardless of the limited amount of knowledge they may have. Ultimately, this can harm the long-term returns of an investors portfolio.

Investors should therefore have a thorough understanding of the company and industry they're looking to invest in. Doing so will provide investors a significant advantage when valuing the company and determining what price to pay for the company.

In closing, different people understand different businesses. The important thing is to know which ones you do understand and when you're operating within your circle of competence.