“Circle of competence” is a phrase which is often used in the investment circles (pun intended). Basically, one should invest in companies and organizations that he/she knows, and by knowing very well how they are structured, operate, sustain and of course, be profitable.
While the term “circle of competence” is easily bandied about, it is not so simple while trying to put it into practice. For everyday retail investors like you and me, the main (or probably only) company/organization that we may have competence is at where we work. Problem is, even though we may be in a company that deals with a certain sector or industry, we do not have the full picture of what is going on, since we are not C-suite employees of the said companies. Also, if we are working at a sunset industry, it is not that wise to invest in it knowing that its growth (and dividends) may be dwindling as time goes by.
Institutional investors, on the other hand, have a large circle of competence; they have an army of analysts who are experts in their own fields to provide inputs, and they have the channels to speak with C-suite executives directly to get a sensing of the goings-on at their respective sectors/industries.
So, does that mean we cannot expand our own circle?
I will provide you four ways on how to expand your circle.
Way #1: Read More
There are tons of resources conveniently available online (business and financial news sites, investment forums, etc.) and offline (business books, periodicals, etc.), so I would think this is the easiest way to start off improving your circle of competence.
Way #2: The Inside Scoop
The next source of information would come from your family members, friends and acquaintances, or rather, their line of work. Although there is no harm in asking about their jobs and the sectors/industries they are in, but this way may seem too mercenary and make your relationships “business-like”. The key thing here is not to ask too much of it in a session and be moderate. If you are not comfortable with it, then just skip this way altogether.
Way #3: Observation
Observation can be done in many forms. One form is to see what products and services that you and others are using. Another is to ask questions on why certain people like to use a product or service, like a personal survey of sorts. After these, continued research is necessary to look at your answers further. Though this may seem incomplete without the whole picture, the ultimate result of any company/organization is to get its customers use their products and services, and these are the people that you are observing/asking in the first place.
Way #4: Go Broad
This is more of a counter-way (and a spoiler) to improve one’s circle of competence, and it is to invest in a broadly diversified market index fund. If you have the whole market in your portfolio, then there are less worries on whether you know a sector/industry sufficiently. However, going broad is likely going to provide average returns, as compared to entering individual sectors/industries.
You can mix-and-match the above ways, such as getting into sector/industry specific funds or adopt a core-satellite approach (Way #4 + Way #1/2/3), or combine ways #1, #2 and #3 together for more holistic research. If you have found a new area in your circle to invest in, do not go all-in and always diversify your portfolio.