Charlie Munger and others have written about the circle of competency with respect to investing. The circle idea is simple. There are things you know and there are things you don’t know. You are unlikely to have a comparative advantage in things you do not know, so focus on your areas of expertise.
If you are an equity investor, you are unlikely to have a competitive advantage in fixed income markets. You may think you have an absolute advantage in everything. You may be right, but that is not the same as comparative advantage. A discretionary investor is unlikely to turn into a good quant. Some one who has focused their thinking on firm valuation will not become an immediate expert in real estate. Of course, crossover knowledge is possible, but realize that switching competency takes time as institutional knowledge is gained. A very good equity retail analyst can become a good real estate investor. The real question is whether that very good retail analyst can become a very good real estate investor. The issue is whether someone can maintain a high level of success across discipline.
Many think the circle of competency is trite. Focus on what you know which is a subset of what is knowable. However, there is a critical danger surrounding the circle. The danger zone is the circle around your competency that consists of what you think you know but you actually do not know. There are a number of behavioral biases, for example, overconfidence, associated with the danger circle of what we think we know. Investors should want to increase their knowledge circle and reduce their circle of what they think they know. If you cannot distinguish between these two, then keep your circle small and decisions focused.
The biggest investment mistakes occur when competency is perceived but it does not actually exist. The Dirty Harry character had a clear view on this issue, "A man's got to knows his limitations."
If you are an equity investor, you are unlikely to have a competitive advantage in fixed income markets. You may think you have an absolute advantage in everything. You may be right, but that is not the same as comparative advantage. A discretionary investor is unlikely to turn into a good quant. Some one who has focused their thinking on firm valuation will not become an immediate expert in real estate. Of course, crossover knowledge is possible, but realize that switching competency takes time as institutional knowledge is gained. A very good equity retail analyst can become a good real estate investor. The real question is whether that very good retail analyst can become a very good real estate investor. The issue is whether someone can maintain a high level of success across discipline.
Many think the circle of competency is trite. Focus on what you know which is a subset of what is knowable. However, there is a critical danger surrounding the circle. The danger zone is the circle around your competency that consists of what you think you know but you actually do not know. There are a number of behavioral biases, for example, overconfidence, associated with the danger circle of what we think we know. Investors should want to increase their knowledge circle and reduce their circle of what they think they know. If you cannot distinguish between these two, then keep your circle small and decisions focused.
The biggest investment mistakes occur when competency is perceived but it does not actually exist. The Dirty Harry character had a clear view on this issue, "A man's got to knows his limitations."
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