Thursday, July 30, 2009 3 comments ++[ CLICK TO COMMENT ]++

Newbie thoughts: Know your circle of competence

I'm going to start two new series for those who started out investing in the last few years. The series will be called Newbie Thoughts and Newbie Mistakes. I will randomly write up on issues that others may find useful. They will range from mundane, simple, ideas to interesting ones. Vetern investors may find them lame and may want to skip over the posts. Also, one should take my comments to be the equivalent of the 'blind leading the blind' because, quite frankly, I'm a newbie too :)

Know Your Circle Of Competence

Once you start investing for real, one of the important things is to know, what Warren Buffett coined as, your circle of competence. Just like in other aspects of life, everyone will have their strengths and weaknesses when it comes to investing.

It is very difficult for those who just started investing—say less than 5 years experience*—to say what is one's circle of competence is. After only trying many different strategies will we know if we are cut out for it or not. Furthermore, we will learn new things as we gain experience and this will expand our circle.

There is some benefit in thinking about your circle of competence, or at least what you think it is. In addition, one may want to think about how to improve your circle.

Even if it looks like a basic thing, you should probably write down what you think your circle of competence may be, and areas that you feel you are strong in and others where you are weak. Once you have such a list, you can set a goal to improve an area or, conversely, automatically ignore potential investments in areas you have no competitive advantage, even if you are attracted to it. For example, let's say you run into a seemingly attractive risk arbitrage opportunity but you feel that you are not cut out for it. Well, even if you are attracted to the opportunity—everyone else may tempt you by saying it's great and a surefire way to make money—you may want to ignore it. Or say you are not very good with sovereign bonds and run across articles or opinion pieces suggesting that Mexican bonds are good. Well, you may decide to improve the knowledge in this area and try to bring that area within your circle of competence. Whether you actually succeed in bringing it within your circle of competence depends on the person but at least you have a plan.

Here is how I perceive myself right now, along with notes on why I feel the way I do. Just because I say something is within my circle of competence and is "strong" does not mean that I'm good at it—all it means is that I feel comfortable and am willing to tackle it.

Center of the circle of competence (strong)

  • Commodities: I haven't taken a long position in any commodity companies lately but I did a lot of research when I first started investing so I think I'm ok on this front.
  • Contrarian opportunities: I feel this is a core strength of mine. Although the record is questionable so far, I have no fear wading into distressed situations or beaten down stocks.
  • General macro: Can't say I have profitted much off this but I do have an interest in general macroeconomic stuff so I feel I'm a bit more knowledgeable than many others I see on the blogsphere. Except for some early profits based on a commodity thesis, I can't say I profitted much from macro. However, I do think it helped me avoid losses.
  • International investing: I'm not really good at this and haven't done much of it yet but unlike many others, I'm pretty comfortable investigating overseas markets. Although one does not need to leave a major market like the US to find good opportunities, there are some advantages to investing overseas. If I'm still an active investor in the future—if I conclude that I'm not cut out for investing, I'm going to be a passive investor—I suspect I will invest mainly outside Canada and USA. You can invest in ETFs and mutual funds but stockpickers should really go for individual securities.
  • Risk arbitrage: I don't think one can really be much of an expert in this field. Put another way, it's hard to develop a competitive advantage over others. At best, you will just be good and avoid many blow-ups.

Boundary of my circle of competence (weak)

  • Technology: I want to develop my skills in this sector. Tech is sort of like consumer goods in the 30's to 60's so it's important for the future. My goal is to significantly improve my knowledge and understanding of this sector. I am already a geeky guy of sorts (in terms of tech products or whatever) but I really don't have a good grasp in terms of investing.
  • Bonds: Know very little, although I have studied them a bit in the last year. I think it is useful to develop some knowledge about bonds. Even if it doesn't help you right now (it may not since we may be entering a multi-decade bear market in them,) it can help you later on in life, perhaps closer to retirement. After looking more at bonds lately, I think I improved my understanding of stocks. It's sort of insightful to look at stocks as a zero coupon super-long-term bond with a yield.
  • Fundamental analysis: Bottom-up analysis is quite weak. I may never become a good fundamental analyst because I find it boring and hated accounting whenever I studied it in school :) But I hope to improve my ability to value stuff. I don't think I will ever be as quantitative as someone like Benjamin Graham but, hopefully, with a mix of qualitative, macro-oriented, insight, and reasonable estimate of valuations, I'll get it right.
  • Taxes: My portfolio is small and I'm near the bottom tax bracket so taxes aren't a big deal right now. At some point, I have to improve my understanding. This also means that companies that make a living by manipulating the tax laws to their advantages are confusing to me.

Areas outside my circle of competence (avoid)

  • Anything to do with biology/health/etc (healthcare, biotech, pharmaceuticals, etc): Of the core sciences, I hated biology more than any other subject in High School :) I am not interested in the field, don't follow it, and, quite frankly, just don't understand it. I automatically rule out any company in these fields.
  • Derivatives: I actually took courses on derivatives in University but I'll probably never use them. I actually invested in warrants before and, although it produced profits (in fact my all-time highest profit on any investment), I think it was a mistake—I was gambling and I never knew it at that time. There are many reasons for avoiding derivatives (options, warrants, futures, swaps, etc.) The obvious reason is their complexity. Even if one understands how to value them, I believe some of the commonly used formulas are flawed and you may be nothing more than an alchemist because chemistry wasn't developed yet. Futhermore, it's not clear to me what advantages small investors have over the professionals when it comes to derivatives. But the #1 reason to avoid derivatives is because they are a zero-sum game. You can still do OK in common stock investing (which is not zero-sum) even if you are not in the top 10% or 20% of investors. But that is not the case for zero-sum games. Those in the 10% in a zero-sum game will likely wipe out all the others and take all the profits. Think about a gambling game where someone else on the table is clearly the best. Do you think you will end up with any money? (some may disagree with my criticism but I have a post coming up on this.)
  • High growth stocks: I looked at growth stocks when I first started investing and quickly came to the conclusion that I'm not cut out for them. I never would have predicted that Apple would skyrocket so much. Perhaps the best example is Google's IPO. I actually thought Google was overvalued at its IPO price. Well, we all know how that turned out (I always remember the Google case because Bill Miller said it was cheap and I couldn't figure out what the hell he was talking about. I actually thought it was one of Miller's mistakes but, lo and behold, it was a correct call, while his bets (much later on) in financials was a mistake.) Clearly goes to show that I can't value growth stocks properly. I try to avoid them. An example of something I avoid right now, even though I am attracted to it, is Mastercard and Visa. These two stocks have very high growth potential but they are outside my circle of competence. (Do note that any investing involves a growth element but I'm talking about situations where growth is the key factor.)
  • Real estate: I am talking about either physical real estate (can't afford them) or companies that deal with real estate (such as REITs). I have spent some time looking at them but I have a feeling that this is beyond me. I just don't understand how to value them. For instance, I was looking at Japanese REITs and I get the feeling that it just doesn't click with me.

I'm sure I'm missing a lot but it's just the beginning. Everyone should probably think about where their strengths and weaknesses may lie...


* Like with any non-investing task, experience does not simply refer to the number of years. The amount of effort and knowledge gained in those years matters a great deal. Someone who has a high opportunity cost of investing—say one with a high paying job, or has kids to take care of, or has to spend a lot of time on relationships, or has a rich social life, or is in school—may be spending far less time than some guy who has a lame job, lives in the middle of the Arctic, and has nothing else to do ;) There are people who have been investing for 15 years but have less knowledge and expertise than some bloggers I read, who have only been investing for 3 or 4 years.


3 Response to Newbie thoughts: Know your circle of competence

Jae Jun
July 30, 2009 at 9:27 PM

This is something that even people with a lot of experience should think about. Thinking you know something is where you are bound to get burnt.

tom brakke
July 31, 2009 at 12:54 PM

When I was done reading the piece and ready to comment, I saw that Jae Jun had stolen my thunder.  The behavioral errors at the investment firms that I study and consult for are not much different than those of individual investors.  Often a simple, common sense analysis like the one you describe is remarkably effective at building a foundation for better analysis.

Sivaram Velauthapillai
July 31, 2009 at 2:28 PM

Jae and Tom,

Thanks for the comments. I agree that this is something that everyone should be doing.

Post a Comment