"That is the key, defining your circle of competence. The important thing is not how big your circle is, but its staying inside the circle."
The first question that was asked in this segment was about Warren Buffett's qualitative and quantitative analysis of companies, and whether or not he has bought a company when the numbers tell him not to. This was his response.
"The best buys have been when the numbers almost tell you not to. Then you feel so strongly about the product and not just the fact you are getting a huge cigar butt for cheap."
If you have read Philip Fisher, you probably understand the analogy "cigar butt". A cigar butt is basically a company that has one last puff of profitability left in it that is highly undervalued, so you are able to make a one-time profit out of it.
Buffett then went on to explain why cigar butt investing is not a good strategy. These companies do not have repetitive profitability. Ultimately you want to own companies that has great future economics for a long time to come.
Buffett continues by saying that he understands qualitative as soon as he gets the phone call.
"If you don't know enough about the business instantly, you would not know enough in a month or two. You have to have a background of understanding and know what you do understand and what you don't understand. That is the key; defining your circle of competence. The important thing is not how big your circle is, but it is staying inside the circle."
This idea of circle of competence is very important in developing one's investment philosophy because it allows you to truly be comfortable with your investments. You will be fully knowledgeable about certain companies or industries. This will make the investment process much easier because you will fully understand your purchase, hence reducing the amount of work needed to evaluate companies. Right now, I am in the process of understanding certain companies and industries to improve my circle of competence. My goal is to sleep comfortably at night knowing my purchases were knowledgeable, informed and will ultimately earn me an above average return.
I have decided to incorporate how Warren Buffett's investment philosophy applies to life as well. It is very obvious that Warren Buffett's way of thinking is both consistent with his life and investing principles. I always thought it to be important to know what you enjoy doing and just do that; in a sense, stay within your circle of competence. There are many times where we are persuaded to do things that we know we are not comfortable doing, only to experience an unpleasant outcome. Don't misunderstand what I am saying. I am not saying avoid new experience or challenges; what I am saying is it is important to make wise, informed decisions based on your knowledge of a particular situation. Look at the upside versus the downside, or analyze the various outcomes if different choices are made and then decide. This way, at least you were aware of the different risks involved and you would be more prepared and comfortable with the outcome.
Warren Buffett MBA Talk | Part 1: Integrity
Warren Buffett MBA Talk | Part 2: Smart Choices
Warren Buffett MBA Talk | Part 3: Choosing Businesses
Warren Buffett MBA Talk | Part 4: Share of Mind
Warren Buffett MBA Talk | Part 5: Circle of Competence
Warren Buffett MBA Talk | Part 6: Macroeconomic Factors
Warren Buffett MBA Talk | Part 7: Inactivity & Dividends
Warren Buffett MBA Talk | Part 8: Diversification
Warren Buffett MBA Talk | Part 9: Market Cap
Warren Buffett MBA Talk | Part 10: Ovarian Lottery