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Warren Buffett on How to Be a Smart Investor

Being a great investor requires a detailed understanding of what you don't know as well as what you do know. This might seem like a silly suggestion at first, but it all has to do with the circle of competence.

Know your limits

Great investors know where their sphere of expertise is, and they don't stray outside this boundary.

In some respects, this approach is counterintuitive. It is easy to think that with so many investments on the market, investors should understand as many sectors and industries as possible to take advantage of any opportunity when it presents itself, but that is just not true.

Indeed, Warren Buffett (Trades, Portfolio) is a big believer that investors do not have to have a high IQ and a detailed understanding of every single corner of the market in order to be successful. Instead, he believes that investors should have enough common sense to know where their boundaries lie.

In a 1994 Q&A session after a lecture with students of the University of Nebraska, the Oracle of Omaha said:

"I do find it amazing how many people with high IQs get off the track. It's astounding to me how people who are really very smart manage to engage in so many self-destructive actions, and I'm not just thinking in terms of business. I have no real prescription, as I look around at the people whom I think are extremely sensible. I don't know quite how to transplant that or teach that to other people. I think a lot of people make things more complicated than they need to.

There is nothing complicated about the way we invest. It is very understandable."

Take your time

According to Buffett, one problem is that large numbers of investors just don't understand the companies they are buying and fail to do enough research before committing to a transaction.

"I've felt that before people buy a stock, they should take a piece of paper and simply write 'I'm buying General Motors at 47,' or 'I'm buying US Steel at 83.' They should just write out what their reasoning is, and they should be able to get it all on one side of one piece of paper. In fact, they should be able to get it into a paragraph. Almost all of the big, great ideas in business are very simple.

Sam Walton's idea was very simple at Wal-Mart. It's not hard to do. If you want to accomplish something, and this ties in a little bit with common sense maybe, you have to have focus. Mrs. B had focus. Mrs. B never went to school a day in her life, and she ran rings around all kinds of people because she's smart and energetic. She was also focused. Tom Watson, who started IBM, was the same way. He said, 'I'm no genius, I'm smart in spots, but I stay around those spots,' and there is a lot to that."

Avoiding disaster

There's no surefire way to be a successful investor or business owner, but by keeping things simple, it can be easier to avoid disaster.

Buffett has built Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) into one of the world's largest businesses by only investing in companies he understands. You could say the same about many other global business champions.

At the same time, there are hundreds of thousands of other business managers who have got themselves into trouble by trying to expand into a market they did not understand. That's where the common sense element comes in; knowing what you don't know isn't particularly challenging, but having enough common sense to remember not to make a mistake is the hard part.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.