The real Warrent Buffett 2 - The Circle of Competence

In complex environments,  the successful expert is creating a “simulation” of the  system in  their  head that  is populated  with information from many different sources. Somehow the diversity of information  in  their  brain  creates an  emergent  solution  to the problem.

Norman  Johnson1

We  try to think  about  things  that  are important  and knowable. There are important  things that are not knowable…  and there are things that are knowable but not important—and we don’t want to clutter up our minds with those.

Warren Buffett

We don’t have a master plan. Charlie and I don’t sit around and strategize or talk about the future of various industries or anything of that sort. It just doesn’t happen…  We simply try to survey the whole  financial  field  and  look  for  things  that  we  understand, where we think  they have a durable competitive  advantage, where we like the management  and where the price is sensible.

Every decision  he takes in the  allocation of capital is taken from a position of utmost  psychological security. His Circle of Competence is indispensable in this regard.

Thomas  J. Watson  Sr.  of IBM  followed  the  same rule: “I’m no genius,” he  said. “I’m smart  in  spots—but  I  stay around  those spots.”

Warren Buffett4

I’ve learned the perimeter of my circle of competence.  If you name almost any big company in the US, I can tell you in five seconds whether or not it is within my circle of competence,  and if it is I’ve

probably got some sort of fix on it.

Warren Buffett

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen,” Buffett claims.

In the short and medium  term,  the direction  and scale of events are therefore dictated  by contingencies that cannot  be determined.

Years ago no one could  have foreseen the huge expansion  of the Vietnam  War, wage and price controls, two oil shocks, the resig- nation of a president, the dissolution of the Soviet Union,  a one- day  drop  in  the  Dow  of  508   points,   or  treasury  bill  yields fluctuating  between 2.8% and 17.4%.

It encapsulates a universe  in which he can make an objective assessment  of the opportunities presenting themselves  to him, a universe  in which the  variables he considers  in his decision  making are so manifest that  he can almost  touch  them,  and where he is so sure  of them that  he can essentially  eradicate  uncertainty.

In order to administer this state of cognition,  Buffett proscribes  for himself  the  Circle  of Competence shown  in Figure  2. He draws this according  to the following instructions:

1   He  establishes what  he  knows by identifying  truths,  the  dynamics that  sit behind  them,  and their  relationships to each other.

2   He ensures that he knows by a process of inversion whereby he seeks to disprove his prior conclusions.

3   He checks that  he knows by seeking out feedback from the  conse- quences  of his decisions.

TRUTHS

Our job really is to focus on things that we can know that make a difference.  If  something  can’t make  a difference  or if  we  can’t know it, then we write it off.

Warren Buffett10

I look for what’s permanent,  and what is not.

Warren Buffett11

Warren  Buffett  says that  he and Charlie  Munger  view themselves  “as business  analysts—not as market analysts, not as macroeconomic analysts, and not even as security analysts.”12

As such,  when Buffett  embarked  on his investment career,  he analyzed every company  in  the  United  States  that  had  publicly  traded securities. In effect,  he started  at A and  worked his way through the alphabet. He says:

As you’re acquiring  knowledge  about  industries  in  general and companies  specifically,  there isn’t anything  like  first doing some reading about them  and then getting out and talking to competi- tors and customers and suppliers and past employees and current employees and whatever it may be. Virtually everything we’ve done has  been  by  reading public   reports  and  then   maybe asking questions  around and  ascertaining  trade  positions  and product strengths or something of that sort.

He found them in the equation for value: in which he incorporates a combination of business economics and the human proposition into a calculus that allows him to judge price.

Buffett’s Circle of Competence surrounds those industries and companies in which he feels confident of being able to identify, comprehend and forecast the dynamics contained in his truths. Perhaps not surprisingly, he restricts this universe of the important and knowable to the simple. “The finding may seem unfair,” he says, “but in both business and investments it is usually far more profitable to simply stick with the easy and the obvious than it is to resolve the difficult.”

INVERSION

 It is, of course, irritating that extra care in thinking  is not all good but also introduces extra error… The best defense is that of the best physicists, who  systematically criticize  themselves  to an  extreme degree… 

as follows: The  first principle  is that you must  not fool yourself and you’re the easiest person to fool.

Charlie Munger

FEEDBACK

 Part of what you must  learn is how to handle  mistakes and new facts that change the odds.

Charlie Munger26

THE EQUATION  FOR VALUE

 The value of any stock, bond or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that  can be estimated to occur during the remaining life of the asset.

Warren Buffett32

We just read the newspapers, think  about a few of the big propositions, and go by our own sense of probabilities.

Warren Buffett33