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Investing In Your Circle Of Competence

One of our readers recently asked us, “What question must I be able to answer to consider a business to be within my circle of competence?” Thank you for this wonderful question.

Investing within our circle of competence means investing only in companies we truly understand. The term was coined by Warren Buffett and he once said, “One of the things we try very hard to do at Berkshire, is to stay within what I call our circle of competence.” He famously shunned technology stocks prior to the dot-com bubble in 2000 as he didn’t understand them.

A circle of competence for one person might be entirely different from another individual. For example, if you are working in the oil and gas industry, you may intimately understand how companies such as SembCorp Marine Limited (SGX: S51) and Keppel Corporation Limited (SGX: BN4) operate. Someone working in the aerospace, or specifically in the aircraft maintenance, repair and overhaul industry, will appreciate the inner workings of SIA Engineering Company Limited (SGX: S59). In my opinion, the most important question to ask to consider if a particular business is within your circle of competence is, “Do I understand the business?” If you understand the business, the next question to ask would be, “How does the business make money?

Instead of asking questions, you could also do the Peter Lynch Test. He said that one specifically should be able to explain his/her thesis in three sentences or less in a way an 11-year-old can understand. Or another variation of this test would be illustrating your investment idea with a crayon. If you cannot do so in either instance, the business might not be within your circle of competence and it is better to skip it. The “tests” are effective as they force you to fully understand the business before you can “attempt” them.

Foolish Bottomline

Defining our circle of competence and investing within it is extremely paramount. If we invest in things that we do not understand, we may make unnecessary emotional decisions, affecting the long-term returns of our portfolio. Warren Buffett and Peter Lynch invest only in things that they understand. By investing within their circle of competence, they have amassed a great fortune for themselves and their shareholders alike.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.  Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.