the real world of finance. The sooner we accept that we live in an uncertain world—that we don’t have all the answers—the sooner we can begin trying to become wiser. This understanding is vital. Once accepted, it shapes our worldview and becomes a natural way of thinking. Incorporating uncertainty in the way we think about what we believe creates open-mindedness to alternative hypotheses, moving us closer to a more objective stance toward information that does not align with what we believe—that is truth seeking.
With respect to investing, intellectual humility is best illustrated through the concept of the circle of competence.
The Circle of Competence
I’m no genius, but I’m smart in spots, and I stay around those spots.
—Tom Watson Sr.
Warren Buffett has always advised investors to focus on operating only in areas they understand best. In HBO’s documentary Becoming Warren Buffett, he compared his investing strategy to America’s favorite pastime, referencing baseball legend Ted Williams’s book The Science of Hitting, in which the all-star slugger emphasized the importance of knowing your sweet spot: “If he waited for the pitch that was really in his sweet spot, he would bat .400. If he had to swing at something on the lower corner, he would probably bat .235.”5
The lesson for investors, Buffett says, is that we don’t have to swing at every pitch: “The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!’ ignore them.”
Just as Williams only swung at pitches in his sweet spot, Buffett only invests in companies that are within his “circle of competence,” a concept he described for the first time in his 1996 letter to shareholders: “What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital [emphasis added].”6
This means that, as investors, we need to restrict ourselves only to those businesses whose long-term economics we can understand. For most investors, investing outside one’s circle of competence is what often leads to big losses. One should not blindly chase “buzzing stocks” or get swayed by exciting “stories,” “narratives,” or “futuristic” concepts, because these kinds of businesses usually have unproven track records or they lack profitability and cash flow.
The key idea behind the circle of competence is not its size—the absolute number of businesses you can understand—but your awareness about its size—the kind of businesses you know you can understand.
It is not important how big that circle is. What matters is how well you have defined its perimeter. Investors who are intellectually honest and humble are always willing to admit their limitations and to stay within their area of expertise.
So, how do you find your circle of competence?
Instead of picking what you know, use the inversion technique, popularized by Charlie Munger, to create your circle of competence. Inspired by the German mathematician Carl Gustav Jacob Jacobi, Munger explains,
Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead—through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.7
Try to know the things you don’t know, and then draw a circle that keeps those things out. (This is very much what scientists do. They approach a problem and its solution by trying to prove it is false, not that it is true.)
In investing, risk comes from not knowing what you are doing. In fact, Buffett considers this to be one of the biggest risks in investing. So much so that he avoids using equity risk premiums to value stocks, confining himself only to those situations about which he is highly certain. Buffett uses the interest rate of long-term U.S. Treasury bonds to value stocks, except when he believes it is artificially low. During those times, he adds a few percentage points to his discount rate. He says, “I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing.” In a similar vein, Buffett adds, “We don’t discount the future cash flows at 9 percent or 10 percent; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”8
At the 1998 Berkshire annual meeting, Buffett explained how he thinks about risk when evaluating any business:
When we look at the future of businesses, we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know—that it’s risky for us. It may not be risky for someone else who understands the business. However, in that case, we just give up. We don’t try to predict those things. We don’t say, “Well, we don’t know what’s going to happen. Therefore, we’ll discount some cash flows that we don’t even know at 9 percent instead of 7 percent.” That is not our way to approach it.9
How does such strict adherence to his circle of competence greatly help Buffett in investing? He explains: “If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll make more money in a business where we know what the end game will be if it bounces around a lot.”10
If you know things you don’t know—your circle of incompetence—you will automatically get to what you do know—your circle of competence. Once you have defined your circle of incompetence, draw your personal circle, just as Buffett did. Buffett’s investing process involves creating three lists of companies—in (simple and easy-to-understand businesses), out (difficult to understand), and too hard (so complex that it is not worth devoting any time to understanding them). Buffett once said that 99 percent of the stock ideas that came to him fell into the too hard category.
Just think about that for a minute. In Buffett, we have arguably the greatest investor who has ever lived admitting that he does not understand 99 percent of the businesses he comes across. The next time you feel you know it all, reflect deeply on that fact. A genuine and honest adherence to one’s circle of competence is a deeply humbling experience. Let me share a personal example, to illustrate. In January 2018, I came across the most recent edition of Indian Economy & Market magazine, which contained investment thesis reports on “75 Hidden Gems,” many of which had been written by my respected seniors and peers. I could properly understand only one name out of seventy-five. This is perfectly acceptable. Remember, it is not a competency if you don’t know the edge of it. Venturing outside these edges is what gets investors into big trouble.
Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points. People chronically misappraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant [emphasis added].
—Charlie Munger
One sign of emotional intelligence is the ability to admit error. A mistake denied is a lesson not learned. Reflect deeply and objectively evaluate your performance. It is only through an honest self-assessment that an investor can discover his or her circle of competence. A key benefit of emotional intelligence is the intellectual honesty to view the world as it really is, not as one wants it to be, hopes it to be, or wishes it to be. My investing strike rate improved significantly once I acknowledged what I do not know and stayed within my circle