Thursday, February 18, 2016

Charlie Munger and circle of competence...

Munger has a range of approaches he uses to avoid mistakes. To make this point by analogy, Munger is fond of saying that he wants to know where he will die so he can intentionally never go there. His friend and investor Li Lu described one such approach:  
When Charlie thinks about things, he starts by inverting. To understand how to be happy in life Charlie will study how to make life miserable; to examine how a business becomes big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. —LI LU, CHINA ENTREPRENEUR MAGAZINE, 2010 
By adopting this approach Munger is trying hard to limit his investing to areas in which he has a significant advantage in terms of competence and not just a basic understanding. To illustrate this point, he has in the past talked about a man who had “managed to corner the market in shoe buttons—a really small market, but he had it all.” It is possible to earn an attractive financial return in a very limited domain like shoe buttons, although that is an extreme example of a very narrow circle of competence. The areas in which you might have a circle of competence will hopefully be significantly larger than just shoe buttons. However, if you try to expand that circle of competence too far, it can have disastrous results. Li Lu has written about how Munger has described this point to him:  
The true insights a person can get in life are still very limited, so correct decision making must necessarily be confined to your “circle of competence.” A “competence” that has no defined borders cannot be called a true competence. —LI LU, CHINA ENTREPRENEUR MAGAZINE, 2010 
Once the borders of a circle of competence are established, the challenge is to remain inside those borders. Staying within a circle of competence is obviously not rocket science in theory, but it is hard for most people to do in practice. Lapses by investors are more likely to occur when they meet a slick promoter who is highly skilled at telling stories. This is a case where emotional intelligence, which is very different than intellectual intelligence, becomes critically important. Humans love stories because they cause them to suspend disbelief. Some of the biggest frauds in financial history, like Bernie Madoff and Ken Lay, were excellent storytellers. Stories cause people to suspend disbelief, and being in that state is harmful to any person’s investing process. 
Too many investors confuse familiarity with competence. For example, just because a person flies on airlines a lot does not mean that he or she understands the airline industry well enough to be competent as an investor in that sector of the economy. Using Facebook a lot does not make you qualified to invest in a social media startup. If you have not gone beyond simply using a product or service and have not taken a deep dive into the business of a company, you should not invest in that company. 
Among the people who know how to stay within their circle of competence are the chief executive officers of Berkshire subsidiaries. For example, Buffett once pointed to Rose Blumkin of Furniture Mart as a person who fully understands the dimensions of her capabilities: 
[If] you got about two inches outside the perimeter of her circle of competence, she didn’t even talk about it. She knew exactly what she was good at, and she had no desire to kid herself about those things. —WARREN BUFFETT, THE SNOWBALL, 2008