Circle of Competence: Charlie Munger And Warren Buffett's Greatest Secret

Charlie Munger uses a handful of mental models (ways of thinking about the world) to create outsized business results. One of those models is to always operate within his circle of competence.

I was lucky enough to see Munger speak live at the 2020 Daily Journal meeting in Los Angeles, where he talked about this idea. Here’s what Munger said about his success (paraphrased):

I think about things where I have an advantage over other people. I don’t play in a game where the other people are wise and I’m stupid. I look for a place where I’m wise and they’re stupid. You have to know the edge of your own competency. I’m very good at knowing when I can’t handle something.

Munger is talking about building and operating within his circle of competence, where he has an advantage over other people. 

What Is A Circle Of Competence?

A circle of competence is an area of the world where you have useful knowledge that gives you an edge. 

Here’s the definition from the Farnam Street blog:

Circle of Competence is simple: Each of us, through experience or study, has built up useful knowledge on certain areas of the world. Some areas are understood by most of us, while some areas require a lot more specialty to evaluate.

My brother-in-law is a surgeon. He has a circle of competence in that field built from a decade of study and practical application. Most people don’t have his circle of competence and can’t easily obtain it. It’s not something you can read a few books on and then go out and practice. His circle of competence is very specialized.

On the other hand, most people can quickly understand and apply the economics of building and selling a digital info product. You only have to build the product once, and then you can scale it with media and code and sell it to anyone with an internet connection. Most people can add this to their circle of competence easily. 

Warren Buffett wrote a letter to Berkshire Hathaway investors in 1996 that lays out what it means to operate within your circle of competence. In it, Buffett advises investors that they should focus on evaluating the strength of selected businesses - businesses within their circle of competence. 

Most importantly, he insists that “the size of that circle is not very important; knowing its boundaries, however, is vital.” 

Here’s Buffett in his own words:

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. The size of that circle is not very important; knowing its boundaries, however, is vital.

In life and business, the goal is to build a circle of competence and then operate within it - to play in areas where you are “wise” and others are “stupid.”

Examples of Circles of Competence 

Warren Buffett And The “Too Hard” Pile

Warren Buffett and Charlie Munger have built Berkshire Hathaway by only buying businesses they understand. They never step outside their circle of competence. 

Here’s Buffett on the optimal business-picking formula:

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.

Buffett uses the phrase “easily-understandable.” You must understand how the business works if you are going to invest in it. Buffett even has a pile on his desk that he calls the “too hard” pile. Any business that is too difficult for him goes into this pile.

Charlie Munger And Areas of Advantage

Early in his life, the ever-practical Charlie Munger - Buffett’s partner - tried to answer the question: “Where should we devote our limited time in life, to achieve the most success?”

To Munger, the answer became clear: play in areas where you have an advantage in life. Know your strengths and where you have an edge, and stay around those spots.

Here’s Munger in his own words:

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.

How to Build Your Circle of Competence

Accept That You Already Have One.

Unless you’ve been proactive in building a specific circle of competence from an early age, then your life circumstance, interests, skills, and natural inclinations have made one for you. 

Naval Ravikant has a concept called “specific knowledge” that I think is applicable here. In this case, specific knowledge is very close to a circle of competence. Here’s Naval:

The first thing to notice about specific knowledge is that you can’t be trained for it… [it’s] found much more by pursuing your innate talents, your genuine curiosity, and your passion… [it’s’] the knowledge that you care about. Especially if you’re later in life, let’s say your post 20, 21, 22, you almost don’t get to choose which specific knowledge you have. Rather, you get to look at what you have already built by that point in time, and then you can build on top of it.

I’ll be honest - when I first read this, I was mad. I wanted to define my specific knowledge and circle of competence, not have it defined for me in my late 20s. 

But I changed my perspective once I decided to lean into the skills I already had: writing and producing. What I learned is that when you lean into the stuff you’re already good at and make a concerted effort to improve those skills, you’ll quickly get traction in your industry. 

My goal now is to become a better writer and producer every day. And to be prolific in those fields. 

So, if you’re disappointed to hear that your circle of competence is already defined, take a step back. Look at what you’re good at and lean in. I think you’ll change your mind once you start finding some traction and success. 

Work To Define the edges.

Charlie Munger likes to say that “knowing what you don’t know is more useful than being brilliant.” You have to define the edges of your circle of competence and know when you’re outside of it. 

When you’re securely inside your circle, you have an edge. When you’re outside of it, that’s when things get dangerous.

Here’s Munger again:

It is really important to stay within your circle of competence. If you are not sure what the boundaries of that circle are for you, then you do not have real mastery of your field.

You have to know your blind spots. Or at least understand that you have blind spots and gauge whether you need more information or different information to make a decision in your field.

Slowly Expand Your Circle Over Time.

This is something I was confused about early on. If you have a circle of competence, and you’re not supposed to step outside of it, how do you expand it? Should you expand it?

Yes! Your circle of competence will be bigger a decade from now if you commit to chipping away at the edges every day. 

Don’t catapult yourself ten miles outside your circle. Just take a pickax to the edges by learning something useful every day. To be a life-long learner is a competitive advantage. Never stop chipping away.

Munger says:

If you’re going to live a long time, you have to keep learning. What you formerly knew is not enough. If you don’t adapt, you’re like a one-legged man in an ass-kicking contest.

Why It’s Important To Stay Within Your Circle of Competence

You Avoid Blowing Up.

The most important reason to operate within your circle of competence is that it protects you from making a major mistake that puts you back to “zero.” 

In an article called You Are Defined By Your Worst Day, Not Your Best, I write:

At some point, you will have to face the downside of one (or many) of your decisions. Whether it’s an investment decision, business decision, or personal decision, one of them, at some point, will turn on you. And when that happens, the most important thing is that you avoid ruin.

Operating within your circle of competence helps you avoid ruin when you do make a mistake. Buffett says:

You only have to do a very few things right in your life so long as you don’t do too many things wrong.

Watch the downside of your decisions carefully. Make sure that if the worst-case scenario happens, you survive to play another round.

You Can Win Big.

If you use leverage (capital, code, media, or labor) to magnify the impact of your decisions, you only need to make two or three great bets in your circle of competence to win big. 

And those bets have to be large. Confidence and bravery are critical to the kind of success enjoyed by Munger and Buffett. When you see an opportunity where you have the edge over others, load up the truck. 

Here’s Munger:

An idiot can diversify a portfolio, or a computer. But the whole trick of the game is to have a few times when you know something is better than average, and invest only where you have that extra knowledge. If that gets you a few opportunities, that’s enough.

One or two great decisions in your circle of competence can change your life.

Start now.

Special thanks to Emma Cranston for her help in creating this article.

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ARTICLE SOURCES

https://fs.blog/2013/12/circle-of-competence/

https://nav.al/specific-knowledge

Buffett, Warren. Berkshire Hathaway Letters to Shareholders, 2017. Explorist Productions. Kindle Edition.