To most investors in the financial market, the names Warren Buffet and Charlie Munger need no introduction. Investors closely track their strategies, portfolios, and advice to replicate their returns. However, it is not as easy as it may seem. Although the reasons for this could be manifold, one significant reason could be overlooking the circle of competence model.

In this article, we will discuss the meaning of the circle of competence, its benefits to investors, and how it can be applied to craft suitable investment strategies that work for you.

The circle of competence can be explained simply as a mental framework that can help you find out your strengths. If you do not know what you are doing and make decisions with incomplete knowledge, there is a higher chance of making a mistake. Buffett’s original thought behind the concept was that investors do not need to assess all the companies in the market. Intelligent investing is simple but not easy. Investors should focus on analysing a few companies that fall under their circle of competence. The circle’s size is not the most important aspect of the model. Rather, what’s important is to know the boundary.

Knowing the limits of your circle of competence enables you to make self-aware investment decisions and can be invaluable in the long run.

With the meaning of the circle of competence clear, let us examine some benefits of investing and trading within your unique circle:

• Fewer mistakes
  Mistakes in the financial market can cost you heavily. Thus, reducing the error rate in your investment portfolio will empower you to push your profits even higher and reduce losses.
• Knowledge is power
  Smartly investing according to your unique circle of competence can give you an edge over others in the market who trade beyond their circles.
• Simplified stock selection
  One of the marks of a seasoned investor is knowing which opportunities to pass and which ones to grab. This is exactly what is meant by trading according to your circle of competence. It also helps shortlist stocks, making portfolio selection easier.

Also read: Call and put options

The next point of discussion will help you understand how you can figure out your own circle of competence. Before discussing the things to do, let us state one thing you should not—be overconfident. This is the most common obstacle to improving self-awareness. If you approach the exploration process with honesty, you will be able to easily identify your circle.

The first step in this process is to identify which sectors or industries you have in-depth knowledge about. You can ask yourself the following questions.
 

How does the industry work?

You should understand how the industry and its companies work. Stay on top of revenues, operations, profitability, and other metrics that can help you compare historical and present data.
 

What are the profits of the chosen company?

You should also know the revenue streams and profitability of the company you decide to invest in. This will help you understand its growth prospects and how it fares against competitors.
 

Does the company have the potential to survive competition?

Competition is vital for a business. In the globally competitive and dynamic business landscape, every company needs to have a robust business model to survive competition. This is why you need to be sure of the potential of your chosen company.

When you commit to the process of finding your circle of competence, you may have many such questions that will be helpful in decision-making. Even though it may take time to fully develop the framework, once you sort it in your head, it will serve you well for the rest of your life.

However, to each their own. Instead of finding stocks you relate with, some investors like to list stocks that they believe are surely outside their circle of competence and arrive at the preferred stocks by intense selection.

Also read: Margin trading

Assuming you want to start trading in your circle of competence, we will lay down some steps and tips that will help you leverage the circle in your investment strategy. These are:

• First step
  Firstly, make a big list of shares that you want to buy. The shortlist could be based on any factor or reason.
• Second step
  Now, you should assess every stock and ask yourself the questions mentioned above. If the answers are negative, then skip them. The stocks with positive answers can be listed separately.
• Third step
  The third step is getting down to the company level and understanding its business and financial model.
• Fourth step
  Then, the companies that have emerged green can be finalised as the definition of your circle of competence. The idea here is not to have a large number of companies but to know the companies in the portfolio in-depth. The circle can also be expanded as you garner more knowledge and experience.

Understanding and leveraging the Circle of Competence allows investors to make more informed and confident decisions by focusing on their areas of expertise. This approach minimises the risks associated with stepping into unknown territories, making it especially valuable in investing.