If you ever read about the investing practices of legend investor Warren Buffet or intend to follow his successful investing style, you would have reached and probably stuck with a term ‘circle of competence’.
Buffett always use this term whenever he speaking about investments or to shareholders. This is an article simplifying the term ‘Circle of Competence’ for your better understanding.
‘Circle of Competence’ is nothing but, it is a self defined boundary which includes the businesses or services that you are well able to understand and valuate.
I will start with an example using my own ‘Circle of competence’. I had built and maintain my own circle of competence with the companies who manufacturing products that required by each and every public in my nation. It can be any service or any FMCG (fast Moving Consumer Goods) or whatever it is. I have a company in my boundary, and I am able to interpret their business, cost and profit from the product, marketing methods, research facility, business quality and management efficiency.
Through such necessary information required as an investor, I am able to understand the long term profitability if I invest to the company. Once I have understood the company and its relatively strong fundamentals, it is my turn to understand whether the present prices are suitable for me to buy the company stocks. Once if I found the prices is suitable, I can buy the company stocks as much I can, because, I know the company is fundamentally strong and able to generate wealth for me in each and every moment.
Through the ability of understand the business of a company, I made this company inside my circle of competence. But in the same time, I will tell you how a person required to avoid some companies from his circle of competency. I am again using my own example: all you have heard about the company Intel well. I too. But, I was not able to understand what their core business. I just know they are the manufacturers of computer chips but, I don’t know who all their major customers are. Also, I am not able to understand the material and technology they are using to manufacture the chips. Thus, I am not able to understand the manufacturing cost or the possible profit on each unit. This is the reason I stop the company outside my Circle of Competence.
Once after building your circle of competence, you have multiple benefits. First, you don’t need to worry about what is happening with any companies that is outside your circle. Second, you will have more focused approach to identify the best company among the companies operating to the same sector, where you have enough knowledge. This will make you able you to understand the right price of your company comparing with its peers. A great deal !!
Hope you now have got the right idea about ‘circle of competence’. Also, the importance of build the circle of competence. It is a simple process process of including businesses and services that you are able to interpret and excluding the business or sectors that you are not able to understand.
Once after building your circle of competence, you can identify the best companies in each business and services. That will be your starting point to understand the right price to buy their stocks.
I hope, I have explained the term in a simple way. If you have still doubts, please look below for the comment box and just comment here with your doubt. I will reply with answer to your any queries, at the earliest.
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