Lesson 5 of 7
Your circle of competence
Your circle of competence is what you can actually judge. Its edge matters more than how large it is.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Your circle of competence is whatever you understand well enough to judge, not whatever you feel confident about.
- Its edge matters more than its size: know exactly where a small circle ends before you try to widen it.
- Staying inside it is a choice made before you look at a price, not an excuse made after a loss.
Your circle of competence is the set of businesses you understand well enough to judge on your own. Buffett's 1996 letter puts the size of that circle second. Knowing exactly where its edge sits comes first. The same passage opens by saying most investors are best served by a low-cost index fund, and addresses the circle to those who choose to build their own portfolio.
Where does a company sit in your circle
RowsCan you explain how it makes moneyColumnsCan you name what would break it
Yes, No
Not yet inside
Yes, Yes
Inside your circle
No, No
Outside your circle
No, Yes
Not yet inside
The edge, not the size
Buffett goes further: an investor needs no course in beta, efficient markets or modern portfolio theory, only the ability to value a business and to think clearly about the price it carries. A narrow circle with a known edge leaves fewer places for a misjudgement to hide than a wide one with soft spots nobody has tested.
Two questions that draw the edge
The grid above uses two of them. Can you explain, in plain terms, how the business turns a sale into cash for its owners? Can you name the one or two things most likely to break that? A third belongs beside them even without its own axis: can you say, roughly, what its profit per dollar of sales, or its return on the money invested in it, ought to look like if it is working the way you think it does. A business where you cannot answer that third question is one you can describe but not yet judge.
The circle is personal, not a list
No industry is inside or outside everyone's circle by default. Its edge is set by the work you have actually done, not by a sector, a market capitalisation or how well known the company is. Two investors can draw their circles in entirely different places and both be right about where their own edge sits. The circle grows only the same way it was drawn the first time, by doing the work on one more business until you can answer both questions about it as well as you can about the ones already inside. That choice is made before you look at a price. Reaching for the circle only after a loss is not the same test.
Check yourself
Per Buffett's 1996 letter, what matters most about your circle of competence?
- Making the circle as large as possible
- Knowing exactly where its edge is
- Matching the circle to whatever is popular that year
Show the answer
Answer: B.
The size is secondary. What matters is knowing exactly where the edge is.You can explain how a company makes money but cannot say what would break it. Where does it sit?
- Fully inside your circle
- Not yet inside your circle
- Fully outside your circle
Show the answer
Answer: B.
Both questions need an answer before a company is inside.What actually draws the edge of a circle of competence?
- How long you have owned the shares
- The work you have done to understand a business
- How popular the company is with other investors
Show the answer
Answer: B.
The edge is earned by the work done on a business, not assigned by its size, sector or popularity.Sources
- Berkshire Hathaway shareholder letter, 1996, on the circle of competence and its edge mattering more than its size.
What this leaves out
- The two-company example is illustrative. It names no real business.
- A circle of competence is judged by you, on your own understanding. Nobody else can certify where its edge sits.
- Nothing here ranks any company as inside or outside anyone's circle, and nothing here is advice about any security.