What is a Circle of Competence?

In the business world, Warren Buffett is recognized as the greatest investor of all time. Warren Buffett's personal holdings are now estimated to be worth over $56.9 billion. In 2007, he was listed as the second-richest person in the world by Forbes .

One of the key’s to Warren Buffett’s financial success is his belief in the circle of competence. The circle of competence is simply the theory that an investor should choose one particular area in which to focus his efforts. Ideally, this should be an area in which his skills and experience are above that of the average investor. According to Warren Buffett, a successful investor does not need to have a large circle of competence; he merely needs to know when he is operating outside his area of expertise.

The circle of competence is a great way for beginners to start investing in stocks because it narrows down the list of available options into something that seems much more manageable. Since this investing strategy plays on an individual’s own unique perspective, it also makes it easier for the novice to develop a better understanding of a company’s competitive strengths and weaknesses as well as its market and products.

Developing a strong circle of competence does not necessarily mean you need to have a degree in business or economics, however. To find your circle of competence, think about your education, personal interests, and past work experience. If you have a degree in computer science, you’re qualified to understand how a software company makes its money. If you’ve spent 10 years working as the manager of a large clothing store, you have an edge in understanding investments in the retail area. If you’re an avid outdoorsman, you are more apt than most to determine which companies have items that will appeal to hiking and camping enthusiasts. Even paying attention to which products your family uses on a regular basis can give you valuable insight into what stocks you may wish to purchase.

Although the circle of competence is a useful tool for determining which stocks you might like to purchase, it shouldn’t be the only factor used in making your decision. To be a profitable investment, a company must have an attractive stock price, shareholder-friendly management practices, and a solid plan for managing future growth. Once you’ve determined your circle of competence and identified a list of prospective stock purchases, analyzing company documents such as balance sheets and income statements is the next step in successful investing.