Understanding your circle of competence can help you avoid problems and identify opportunities for improvement.
Either through experience or study, all of us have built up useful knowledge on certain areas of the world. Some areas are common knowledge and are understood by most of us, while some areas require a lot more work to understand.
For example, most of us can understand the economics of running a restaurant or a coffee shop. You rent or buy space, spend money to outfit the place and then hire employees to serve, cook, and clean. You'd then focus on generating traffic and setting the appropriate prices to generate a profit. Though the menu, prices, and ambiance will vary by restaurant, they all have to follow the same economic formula. This basic knowledge, along with a bit of research, would enable one to evaluate any number of restaurants.
Can most of us say we understand the workings of a technology company or a biotech drug company at the same level? Perhaps not.
Warren Buffett and Charlie Munger have used the concept of the Circle of Competence as a way to focus on only operating in areas they knew best. As Warren Buffett wrote in his 1996 Shareholder Letter:
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.
Charlie Munger took this concept outside of business altogether and applied it to life in general as he sought to answer the question: Where should we devote our limited time in life, to achieve the most success?
You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.
If you want to be the best tennis player in the world, you may start out trying and soon find out that it’s hopeless—that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes the intelligence. But after a while, you’d gradually know all about the plumbing business in Bemidji and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence—which results partly from what they were born with and partly from what they slowly develop through work.
The Circle of Competence is simple. If you want to improve your odds of success, define your circle of competence and operate inside. Of course, you can work to expand your circle of competence over time, but do not fool yourself about where it stands today. As Charlie Munger said,
Knowing what you don't know is more useful than being brilliant.