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The Circle of Competence mental model was developed by Warren Buffett and his business
partner Charlie Munger. It is a model that describes the area of understanding that matches
a person's skills, abilities, or expertise. Buffett and Munger used the model to describe
limiting one's financial investments away from areas you have limited understanding
or expertise and instead focusing on areas where you have the greatest familiarity or
edge. Part of the model involves the importance of accurately assessing one's own abilities
relative to what one may think they might know.
Warren Buffett has said in a 1996 Shareholder letter:
"Know your circle of competence, and stick within it. The size of that circle is not
very important; knowing its boundaries, however, is vital."
"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."
-(Warren Buffett)
While Buffett and Munger have popularized the idea of a Circle of Competence within
which we focus our efforts, the concept itself could be traced back even further to the earlier
business titan, Andrew Carnegie who made his vast fortune by focusing his efforts within
the iron and steel industry. Carnegie is quoted as saying,
"My advice to young men would be not only to concentrate their whole time and attention
on the one business in life which they engage, but to put every dollar of their capital into
it." -(Andrew Carnegie)
There are other successful people who have benefited from this way of thinking as well.
IBM Founder, Tom Watson Sr. alluded to this concept when he said,
“I’m no genius. I’m smart in spots—but I stay around those spots.”
-(Tom Watson Sr.)
There are many career paths, callings, and areas of personal expertise in life. The physician
will understand medicine whereas the farmer will understand crop rotation however both
of them may happen to drive a car and so we have both separate circles of competence and
areas where their circles overlap. Just because they overlap in certain areas does not mean
the farmer should try to prescribe medicine. If they stick to what they are best at, they
both will be better off, which shows how Circle of Competence is similar to another mental
model from economics called Comparative Advantage. Comparative Advantage essentially describes
how two trading partners are better off doing what they are best at even if one of them
is better at both. The Opportunity Cost of doing what we are less of an expert in is
just too high. We maintain our edge by staying within our Circle of Competence.
Charlie Munger put it succinctly when he said, "You have to figure out what your own aptitudes
are. If you play games where other people have the aptitudes and you don’t, you’re
going to lose. And that’s as close to certain as any prediction that you can make. You have
to figure out where you’ve got an edge. And you’ve got to play within your own circle
of competence." - .....
"If you have competence, you know the edge. It wouldn’t be a competence if you didn’t
know where the boundaries lie." -(Charlie Munger)
You can tell that Buffett and Munger think along the same lines by what Buffett had to
say about defining your Circle: "The most important thing in terms of your
circle of competence is not how large the area of it is, but how well you’ve defined
the perimeter. If you know where your edges are, you are way better off than somebody
who has a circle five times as large but is very fuzzy about the border.""
-(Warren Buffett)
This is not to say that our circles can't get larger, we can widen our Circle of Competence,
however it is a slow process that can take a lot of time. It could then be argued that
this time could best be spent where it gives the most leverage, which is of course, areas
already within our Circle of Competence.
When Warren Buffett first started out in business decades ago, he soon realized that the insurance
industry was something he intuitively understood. He also admitted that he did not particularly
understand the retail industry even though he spent some time working in it when he was
young. Much of his success can probably be attributed to the fact that he recognized
early on what made sense to him and focused on that.
Beyond focus, It is also important to have the right mindset. Just because you lack knowledge
in an area should not persuade you towards an attitude of ignorance or learning apathy.
Increasing our circle by connecting new knowledge and ideas within our latticework of understanding
should be part of our life's purpose. This is true for Munger who admits much of his
success comes from his wide learning interests.
“I paid no attention to the territorial boundaries of academic disciplines and I just
grabbed all the big ideas that I could.” -(Charlie Munger)
Learning the right knowledge may take us outside our current area of competence but it could
also end up linking with areas we do have competence in. As we fill in the gaps, make
connections, and pursue our learning niche we can develop what Naval Ravikant calls Specific
Knowledge.
"Specific knowledge is found by pursuing your genuine curiosity and passion rather than
whatever is hot right now." ..... "Everybody wants to get rich immediately,
but the world is an efficient place; immediate doesn’t work. You do have to put in the
time. You do have to put in the hours, and so I think you have to put yourself in the
position with the specific knowledge, with accountability, with leverage, with the authentic
skill set you have, to be the best in the world at what you do. You have to enjoy it
and keep doing it, keep doing it, and keep doing it. Don’t keep track, and don’t
keep count because if you do, you will run out of time."
-Naval Ravikant
Another important aspect of the Circle of Competence is that it can be helpful to be
aware of what we actually know versus what we may just be exposed to recently. The Vivid
or Recent Availability Bias is where things we are exposed to recently or which come to
our minds vividly become things we assume that we know with a higher degree of confidence.
If we are familiar with something enough to think of it, we may assume that we fully understand
it or if we just happened to have a news story fresh in our mind we may be biased into believing
we are competent to judge that area. Knowing the true limits of our Circle of Competence
is important in order to avoid personal cognitive bias and errors of overconfidence.
"If knowledge is power, knowing what we don’t know is wisdom."
-(Adam Grant)
These biases tie into a concept from social psychology called the Illusion of Explanatory
Depth where people have the illusion that they know something well or are competent
but when they go to actually explain the topic they are unable to do a very good job explaining
it. Their depth of understanding was merely an illusion.
It can actually be common to believe that we have more knowledge or understanding than
we actually do. the Dunning-Kruger Effect applies to the Circle of Competence as well
because the Effect basically describes what happens when people gauge their own abilities.
Average performers tend to rate themselves as above average while above average performers
tend to see themselves as average.
Clearly being aware of the myriad of cognitive biases that can affect our judgment can be
an important part of accurately determining where our Circle of Competence actually lies
so that we can be honest with ourselves and make better decisions from a place or strength
rather than weakness.
The Circle of Competence mental model is simple to understand and the lessons are clear. If
we want to increase our odds of success in investing and life in general, we must know
the perimeter of our Circle of Competence, and operate inside of it with full awareness
of our potential biases. We should also work towards expanding our Circle of Competence
but do so with an awareness that we almost certainly have fatal gaps in our understanding
and that it will take time to develop true competence.
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