Warren Buffett, Mrs. B and the Circle of Competence

Thoughts from Berkshire's 2014 annual meeting of shareholders Continue reading... Read More...

Investors should always ensure that they are staying within their circle of competence and are not buying any stocks they don’t understand.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="However, defining your circle of competence is the hard part. It can be quite easy to trick yourself into thinking you understand a sector or industry when you really don't. I recently encountered a great example of this in a talk by Mohnish Pabrai (Trades, Portfolio).” data-reactid=”13″>However, defining your circle of competence is the hard part. It can be quite easy to trick yourself into thinking you understand a sector or industry when you really don’t. I recently encountered a great example of this in a talk by Mohnish Pabrai (Trades, Portfolio).

Pabrai was speaking about why it is so important to be a harsh grader when it comes to defining your circle of competence. The example he gave was Amazon (NASDAQ:AMZN). Pabrai said that while he used the platform regularly, he could not understand how the business makes any money when it offers free delivery on its Prime service. For just $100 a year, the company offers free delivery on unlimited parcels, whereas sending a product across the country by FedEx would cost $30 on each occasion, he explained.

So, even though the value investor could see the business’s potential, he did not want to invest because he did not understand how the company could consistently make money and support itself when, according to what he knew, he would expect it to lose money on every transaction.

As it turns out, Amazon was able to make money on nearly every transaction, but we also have to take into account survivorship bias. Amazon turned out to be a great investment, but this will not be the case for most other companies you don’t understand.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Defining your circle of competence” data-reactid=”23″>Defining your circle of competence

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Defining your circle of competence is something Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) discussed at the 2014 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders. Buffett gave the example of Mrs. B, who used to own the Nebraska furniture Mart before Berkshire acquired it:” data-reactid=”24″>Defining your circle of competence is something Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) discussed at the 2014 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders. Buffett gave the example of Mrs. B, who used to own the Nebraska furniture Mart before Berkshire acquired it:

“But, we’ve got a number of managers who I think are just terrific at it. I mean, they really know when they’re playing in the game they’re going win in, and they don’t go outside of that game. The ultimate was Mrs. B, at the Furniture Mart. She told me that she did not want stock, in terms of the Berkshire Hathaway deal. Now, that may sound like it was a bad decision. It was a splendid decision. She did not know anything about stock, but she knew a lot about what to do with cash. She knew real estate, she knew retailing, and she knew exactly what she knew and what she didn’t know, and that took her a long, long, long, long way in business life. And that — that ability to know when you’re playing the game in which you’re going to win, and playing outside of that game, is a huge asset.”

This is a relatively simple business lesson, but it is incredibly difficult to implement over the long term. Most investors and business owners will have one sector or industry they know and understand well. Staying inside this industry can be quite challenging, but if you manage to keep yourself from straying into areas you don’t understand, the rewards can be tremendous.

On the other hand, if you do end up straying into parts of the investment world you do not understand, it can be incredibly costly. Mrs. B could have done very well by taking Berkshire stock, but it would have meant buying something she did not understand. That could have been potentially more problematic.

What if Buffett had made a big mistake? What if Mrs. B had gotten scared when the market plunged and sold at the bottom for a loss? These are questions we’ll never know that answer to, but it’s essential to ask and consider them. Investing in something you don’t understand can expose you to risks you don’t understand. Having this kind of exposure is unlikely to generate positive returns.

Disclosure: The author owns shares in Berkshire Hathaway.