Invest within your circle of competence

You make better investment decisions if you understand what you’re getting into. So, invest within your circle of competence.

The phrase was coined by Warren Buffett and his investing partner, Charlie Munger. It means invest in companies you truly comprehend. Buffett notoriously shunned technology stocks during the dot-com bubble because he lacked expertise in the sector. Instead, he continued to invest in companies he understood, such as Coca-Cola. Thanks to this move, he avoided a great deal of pain when the tech bubble burst.

If investors stick to their circles of competence, they gain an edge because they focus on an area where they know significantly more than the average investor.

But tread carefully and be honest with yourself. Don’t invest in a Silicon Valley start-up merely because you’re an avid Facebook user, and don’t invest in an airline company because you travel extensively. Familiarity with or exposure to a particular industry should not be confused with investor competence. You must still do your due diligence and research a company first.

In fact, not having in-depth knowledge and understanding makes it more likely for you to make rash decisions based on emotion. For example, even the most prudent investors couldn’t pass up on the extra yield provided by highly rated debt securities, which were sliced, repackaged and structured in a way that made the possibility of default seem unlikely. But when the subprime mortgage bubble burst, those left holding these worthless securities realized they did not fully understand what they had gotten into.

Although the temptation to join the party may be strong, limiting your investments to your area of expertise allows you to keep your emotions in check, and make sensible decisions. So know and respect the boundaries of your circle of competence.

Peter Lynch, investor and author of One Up on Wall Street, was a big advocate of the “invest in what you know” philosophy. He was familiar with the textile industry, thanks to his experience as a securities analyst. In the 1970s, his wife started buying L’eggs pantyhose made by Hanes. It was the first department store-quality pantyhose sold to women via supermarkets. His wife’s love of the product gave him the insight he needed to recommend this investment to all the portfolio managers in his firm. The investment was a success.

Lynch suggests, before making any investment, you should be able to explain the investment thesis in three sentences or less, and in terms an 11-year-old could understand. Here’s how.

01 Start by investigating the business model.

How does the business make money? You should be familiar with the company’s revenue sources, as well as how much and how often these sources pay. It’s not enough to know that a company sells burgers. You should also know if the company owns its retail space (like McDonald’s does) or if it leases.

Also know how the company delivers its product and brings in revenue. For instance, Gillette is happy to sell its refillable razor handles at or below cost because the company profits through the sale of razor refills.

02 Understand what drives the company’s growth.

How does it stand against competitors? Will the business model be viable five or 10 years from now? What factors could affect demand for the company’s products?

In other words, you must intimately know the business, its finances, its products, its suppliers and its customers in order to say that it fits within your circle of competence. It isn’t rocket science, but it does take a lot of work and dedication to gain a strong grasp on a company’s business. On the other hand, if you decide to use fund managers, then understand their investment philosophies and processes before entrusting them with your money. A fund manager with a good process can still produce poor returns, and a fund manager with a mediocre process can produce good returns. So search for a manager whose investment values jibe with your own.

Whether you choose to invest on your own or to entrust your funds with a manager, knowledge alone can produce the confidence necessary to invest with conviction.

Susy Abbondi is a portfolio manager at Duncan Ross Associates.