The circle of competence is a mental model often used in the stock market to make informed decisions. Charlie Munger, who was the vice chairman of Berkshire Hathaway, always talked about this mental model. He used to say, “If I know where I am going to die, I will never go there.” The same concept holds true in stock markets as well. Knowing what not to do in markets is more important than knowing what to do in markets.
As Suyog Dhavan says in the attached video, “ the circle of competence is like a Lakshman rekha in the investing journey. If you are going to cross that Lakshman rekha, then you are going to suffer.” Mental models, such as the circle of competence, can help you avoid investing disasters. Further in this blog, we will help you understand the concept of the circle of competence in detail, so that you can make the right decisions as a stock trader:
What is the Circle of Competence?
There is a very thin line between what you think you know and what you actually know. This thin line can be considered as the circle of competence. It is the circle of subjects or things that you actually know or that you are an expert in, or of all the subjects that you think you know. Imagine it like this: A bigger circle of all subjects that you know but do not properly understand, and a smaller circle within it that includes things you understand very well. This smaller circle is known as the circle of competence.
Basically, a circle of competence is the area where your experience or expertise lies. You know very well about this area and can make informed decisions related to it. Knowing your circle of competence can make a big difference in your investment journey. If you know and understand your areas of expertise as a stock trader, you can make smarter investment decisions.
Benefits of Knowing Your Circle of Competence
Knowing your circle of competence as an investor can be advantageous for you in many ways. Some of its significant benefits are as follows:
- Fewer Chances of Making Mistakes: Mistakes can cost you very high as a stock trader. Many investors end up losing money not because they choose the wrong stocks but because they invest in stocks without understanding the business or the company. Knowing your circle of competence and investing within that can help reduce the chance of such mistakes.
- Competitive Advantage: By investing within your circle of competence, you can get a competitive advantage over investors who are investing beyond their circle of expertise. Proper knowledge and understanding give you the power of right decision-making.
- Easier to Choose Stocks: If you know your circle of competence, your choice of stocks to invest in becomes easier. It helps you filter out the most relevant stocks and then choose from the filtered ones.
How to Identify Your Circle of Competence?
Now that you know all the benefits of knowing your circle of competence and investing accordingly. The first thing you need to throw away here is overconfidence. Don’t let your overconfidence convince you that you know everything. With a clear mind, you can easily figure out your circle of competence. Just be honest with yourself and start listing down the names of industries that you actually know very well. Now, under these industries, think about which companies or businesses you actually understand. Whatever this last list comes out to be is your circle of competence.
Tips to Invest Using Your Circle of Competence
Below are some tips you can consider when planning to invest according to your circle of competence:
- Take the entire list of stocks that you want to invest in or that fall under your circle of competence.
- Look at every stock and think about whether you understand that company or business very well. If yes, keep that stock in your wishlist. Otherwise, remove it.
- Now, out of all the stocks of companies that you understand, think about which companies are making profits and actually growing. Do you understand their revenue model properly? If yes, keep it.
- Whichever stocks are still there in your list, check their financial records as a last step and invest in companies with good records and the potential to grow.
Learn the Basics of Investing and Important Trading Concepts at Strategic Alpha
Strategic Alpha is a stock learning and mentorship platform that empowers stock traders to invest wisely. The online live webinars held on the Strategic Alpha YouTube channel are highly relevant for beginners and all traders who want to learn. You can learn about different trading strategies, such as techno value investing and more, which can help you achieve your investment goals. Also, you can join the Strategic Alpha Conviction Club to stay updated with the latest trends and learn from experienced mentors, including Suyog Dhavan. For any further information on this, get in touch with us now!
