The Circle of Competence — Know What You Know

Warren Buffett has famously refused to invest in technology companies for most of his career — despite watching them produce some of the greatest wealth-creation events in history. Was he being stubborn? Incurious? Or was he applying one of the most important principles in investing?

Why This Matters

The value investing process begins with estimating what a business is worth. But this immediately raises a problem: how can you estimate the future earnings of a business you do not truly understand? You can run a discounted cash flow model on any company with published financial statements. But the numbers are only as good as the assumptions behind them — and the assumptions are only as good as your understanding of the business. The circle of competence is the framework Buffett and Munger developed for ensuring that the businesses they attempt to value are ones they are actually qualified to assess. It is not a framework for avoiding unfamiliar industries — it is a framework for knowing, with honesty, where the boundary of your genuine understanding lies.