Thoughts on Circle of Competence
One of humanity’s perpetual challenges is to avoid knowing enough about something to think we’re right, but not enough to know we’re wrong.
Studies show that more information makes us more confident about the future, but not more informed about it. Most information is noise, not signal, after all. Data tends to feed our confirmation bias and reinforce prior judgements.
The ability to delineate between what we know and what we don’t is critical to success, especially in investing. As Mark Twain observed ”It ain't what you don't know that gets you in trouble. It's what you know for sure that just ain't so."
The remedy is simple, but not easy: pick your spots, and stick to those spots.
The challenge is, most of us think our spots are bigger than they really are. A study found 88% of Americans and 77% of Swedes consider themselves above-average drivers (Svenson, 1981). Psychologists call this phenomenon Illusory Superiority. It's better known in pop culture as the Lake Wobegon Effect for the fictional town where all the children are above average.
The good news is that size doesn’t matter. Respecting the boundaries of your circle is much more important than the size of your circle.
John Arrillaga is a perfect example. He made $400 million investing in commercial real estate within five blocks of Stanford's campus. He didn’t stray into venture capital, private equity, or emerging markets. He didn’t even invest across town. He stayed close to what he knew and never left his sweet spot.
Mairs and Power, a large mutual fund with an enviable multi-decade track record, invests almost exclusively in companies geographically close to their Minneapolis office. Two-thirds of their fund's assets are in Minnesota-based firms, and most of the rest are in the upper midwest.
A circle of competence doesn't have to be based on geography. Bill Ackman has a nearly perfect record investing in restaurants and real estate. He got burned when he strayed into short selling and pharmaceuticals. Warren Buffett and Charlie Munger have a nearly perfect record of investing in banks, insurance, and branded consumer products. Forays into retail, apparel, and airlines have cost shareholders billions. Joel Greenblatt produced 50% annual returns for a decade focusing on spinoffs and special situations. Shelby Davis only invested in insurance companies. Howard Marks just buys distressed debt. Any niche will work if you know it well enough.
When Mrs. B immigrated to the US in 1917 she couldn’t speak English and had almost nothing to her name. She opened the Nebraska Furniture Mart in 1937 with a $500 loan from her brother. In 1983, she sold it to Warren Buffett for $60 million in cash. She wouldn’t accept Berkshire shares even thought it’d save her a fortune in taxes because she’d never owned a stock and didn’t understand them. She knew retailing though. Her motto was “sell cheap and tell the truth” and she never strayed from it. Rather than hinder her, Mrs. B’s narrow circle of competence helped channel her focus and amplify her talents.
Like Mrs. B, most investors would do well to narrow their focus. Constraints help remove the paradox of choice and allow us to get to the guts of one thing. Like bowling with bumpers, they increase the odds of success by removing the chance of catastrophe.
One way we do this at EPC is by refusing to shorting stocks. The risk/reward is worse than buying which means time spent on a short would be more profitably spent on a long.
We further narrow our focus to simple industries. We like businesses which control most, if not all, of their input and output costs and aren’t changing quickly. Which is more predictable, Coca-Cola or ExxonMobile? Which is more likely to exist in 100 years, Costco or Peloton? Investing awards no points for difficulty.
Simple industries are good, but simple and high-return industries are better. John Arrillaga would have succeeded investing anywhere, but it didn’t hurt that he chose Silicon Valley. It helps to fish where the fish are.
It’s not enough that we know and respect our circle of competence. Our business’s managers must too. The best businesses are often narrow and focused. They stay at the center of their circle and never approach the edges. NVR and AutoZone come to mind. Diversification often turns into diwosification, as Elliot pointed out to Crown Castle this week. This is equally true at the portfolio level. A circle of competence, respected, leads to a concentrated portfolio.
Investing tends to attract smart and ambitious people who want to believe that they have a large and widening circle of competence. Admitting you know less than you think you do requires a level of humility and intellectual honesty few possess. Mastering this is the job of a lifetime.
We don’t kid ourselves that we’ll never stray from our circle of competence, although that’s our goal. An investing partner like Dan offers valuable checks and balances because its not always self-evident when I’ve strayed over my boundary. We do our best not only to stay inside our circle, but keep away from the edges. As rule of thumb, if we wonder whether we’re outside of our circle, we are. To ask the question is to answer it.
Studying the mistakes of others goes a long way towards keeping their lessons top of mind. Any fool can learn from their own mistakes. The real trick is to learn from others. History has shown time and again that investors - like decision makers in any domain - should prefer depth to breadth, the simple to the complex, the obvious to the esoteric, and the enduring to the ephemeral.
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