In his paper The Prospects for Value Investing in China, Li Lu discusses how to master your circle of competence and the importance of clear boundaries. He emphasizes the need for a small, well-defined circle of competence, achieved through focused effort and hard work. Within this zone, you can develop the expertise needed for more accurate predictions and informed investment choices.
Here’s an excerpt from the paper:
Fourth, in his fifty years of practice, Buffett has added one more principle: through unremitting hard work over a long period, investors can build up their own circle of competence. This can give them a deeper understanding than others of a company or an industry, and allow them to make better judgements of future performance. Your unique strength lies within this circle.
The most important part of the circle of competence is the boundary. An ability without a boundary is not an ability.
If you have a point of view, you must be able to tell me the [unsatisfied conditions] for it to be a real point of view. If you just give me a conclusion, it will almost certainly be wrong and unable to withstand scrutiny.
Why is the circle of competence so important? Because of ‘Mr. Market’. What is the point of the market? As far as market participants are concerned, it is to discover the weakness of human nature.
If there are things that you don’t understand, or if you have any kind of psychological or physiological weakness, there will be a situation in the market which exposes you.
Anyone who’s been in the market before will understand exactly what I’m talking about. The market is an aggregate of us all.
If you don’t know what you’re doing there, there will be a moment when the market knocks you down. This is why you only ever hear stories about people making money in the market. But in the end, everyone loses it all. You only hear stories about new people making money because the old ones have all disappeared.
The market can see through your logic and all your problems. If you stray outside of your circle of competence, or if your circle has no boundaries, or if you don’t know your boundaries – there will be some moment when the market takes you to the cleaners.
Only in this sense does investing carry risk. It’s not the price of a stock bouncing up and down; it’s the risk of a permanent loss of capital. Whether this risk exists or not depends on whether you have a circle of competence. And this circle must be very small and very well defined. Only within this tiny circle of competence will you be able through hard work to make good predictions about the future. This is Buffett’s concept.
You can read the entire paper here:
Li Lu – The Prospects of Value Investing In China
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