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Charlie Munger's Guide to Mastering Your Circle of Competence

- By John Engle

While Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) are best known for their success in building Berkshire Hathaway Inc. (BRK-A)(BRK-B), they have also made some substantive contributions to broader investing theory and practice. One of the greatest of these has been their refinement of, and advocacy for, the concept of investor core competence.

The concept has been discussed for years by business professors and investing professionals alike and, while the idea of core competence has taken on a life of its own, Munger has often returned to the subject, discussing it at length in many and varied forums. The most recent such occasion came in February, when he presided over the annual meeting of the Daily Journal Corp. (DJCO).

His Daily Journal speech was in many ways a display of the "classic Charlie Munger" that investors know and love. However, Munger's various reflections on circles of competence and investor knowledge added some genuinely fresh insight to the well-trod idea.

The bounds of the circle of competence

According to Munger (and Buffett), the best way for individuals to ensure they will make successful investment decisions is for them to build a circle of competence that results in their knowing more than others do about a particular area. Importantly, circles of competence are not infinite. At the Daily Journal meeting, Munger admonished his audience on this crucial point:

"It is really important to stay within your circle of competence. If you are not sure what the boundaries of that circle are for you, then you do not have real mastery of your field."

Circles of competence vary from person to person and come in many shapes and sizes. Munger's circle of competence clearly extends to a range of industries, but it is obviously anchored around a deep knowledge of factors that make operating businesses work well.

Most investors will find their circles of competence are more bounded than those of the likes of Munger and Buffett. Yet, whatever their size or complexity, those bounds are vitally important to understand. It is only by knowing the full extent and scope of the discipline, industry or subject area that one can truly begin to master it. This is the heart of subject matter expertise in any discipline, and investing is certainly no exception.

Specialized knowledge trumps diversification

Diversification has its benefits, a fact Munger acknowledges. However, he has long been adamant it is not the best way for investors to make money, except perhaps for those who do not want to think about the market. For those not satisfied with the market return, the only alternative is to develop a circle of competence. That means developing specialized knowledge of a subject matter:

"An idiot can diversify a portfolio, or a computer. But the whole trick of the game is to have a few times when you know something is better than average, and invest only where you have that extra knowledge. If that gets you a few opportunities, that's enough."

In the end, mindless diversification can never match mindful specialization. It is possible to get the market return by buying exchange-traded funds, and diversification undoubtedly does offer insulation from class-specific or industry-specific risks. But if an investor really wants to achieve market-beating returns, then active decision-making is mandatory.

Find your circle

Fundamentally, a circle of competence is not the product of unique or otherworldly wisdom. Rather, it is merely the mundane result of diligent knowledge acquisition about a targeted subject. Any committed individual can build such a circle of competence, given the will to do so.

Investors who are truly committed to winning the investing money game must be willing to do the work needed to build a strong circle of competence.

Disclosure: No positions.

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This article first appeared on GuruFocus.