“We have to deal in things that we are capable of understanding.” Charlie Munger  http://www.youtube.com/watch?v=3XlBrohrIUc

 

“An Investor’s got to know His or Her Limitations” (Apologies to Clint Eastwood in Dirty Harry)

Charlie believes that investors who get outside of what he calls their “Circle of Competence” can easily find themselves in big trouble.  Within a Circle of Competence a given investor has expertise and knowledge that gives him or her significant advantage over the market in evaluating an investment.

The idea behind the Circle of Competence filter is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing.  What could be simpler?  And yet humans often don’t do this.  For example, the otherwise smart doctor or dentist is easy prey for the promoter selling cattle limited partnerships or securities in a company that makes technology for the petroleum industry.

Really smart people fall prey to this problem. As an example, if you lived through the first Internet bubble like I did you saw literally insane behavior from people who were highly intelligent.  Munger has pointed out that even one of the world’s greatest investors stepped outside of his Circle Competence during the bubble:

“Soros couldn’t bear to see others make money in the technology sector without him, and he got killed.” http://everythingwarrenbuffett.blogspot.com/2009/02/motley-fool-notes-from-2000-berkshire.html

In many cases so-called “old money” became so upset at Internet  nouveau riche talking about their money and possessions, they jumped in to the market for technology stocks at the worst time possible, with disastrous  results.

Professors who leave their university can make similar mistakes.  Charlie has talked about the Nobel Prize winner who left academia to help found Long Term Capital Management:   “[When] one of the economists who… shared a Nobel Prize … went into money management himself, he sank like a stone.”  Larry Summers, who is a very intelligent and capable person in Charlie’s view, made a huge mistake investing Harvard’s cash account alongside the endowment leaving exposing the university to a huge liquidity risk. That decision by Larry Summers was clearly outside of his Circle of Competence and both he and the university paid the price. As a more current example, a talented venture capitalist who is within his or her circle of competence may not do as well running a macro hedge fund.

One way to think about what Munger is trying to achieve with this Circle of Competence filter is this: if you make fewer mistakes, your investment performance will be better.  So invest in areas where you are competent.  Why would you buy more of X which you know little about when you can buy Y (or more of Y) which is right in your Circle of Competence?  The Circle of Competence approach is in part a form of opportunity costs analysis which will be discussed later in this series of posts.

Munger argues:

“[Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly.” http://www.watheeqa.com/App_Themes/watheeqa/pdf/Conversation%20with%20Charlie%20Munger.pdf

The value of specialization is, of course, at work here too. Munger in an interview put it this way:

“Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.” http://mungerisms.blogspot.com/2009/08/stanford-lawyer.html

The investor Li Lu describes how Charlie arrives at this approach:

“When Charlie thinks about things, he starts by inverting. To understand how to be happy in life, Charlie will study how to make life miserable; to examine how  a business becomes big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. His way of thinking comes from the saying in the farmer’s philosophy: I want to know is where I’m going to die, so I will never go there.”  http://blog.enochko.com/2010/06/my-teacher-charlie-munger-english.html

To make wise decisions, stay away from domains where you will make unwise decisions.

By applying this filter, Munger is trying hard to limit his investing to areas in which he has a significant advantage in terms of competence and not just a basic understanding.  Munger has talked several times in the past about a man who had “managed to corner the market in shoe buttons- a really small market but he had it all.” That’s an extreme example of a very narrow Circle of Competence. The areas in which you might have a Circle of Competence will hopefully be significantly larger than just shoe buttons.  But if you try to expand that Circle of Competence too far, it can have disastrous results.  Li Lu writes about how Charlie has described this “Mungearian” view to him:

“The true insights a person can get in life are still very limited, so correct decision-making must necessarily be confined to your ‘Circle of Competence.’ A ‘competence’ that has no defined borders cannot be called a true competence.”  http://blog.enochko.com/2010/06/my-teacher-charlie-munger-english.html

In the book Snowball Alice Schroeder argues that Buffett:  “believed in what he called the Circle of Competence,  drew a line around himself, and stayed within the three subjects with which he would be recognized as absolutely expert: money, business and his own life. “(P25)  I find Schroder’s conclusion that Buffett and Munger apply the Circle of Competence rule broadly outside of investing to be unconvincing,  especially since Charlie in particular has strong opinions on just about everything.   Warren may be more circumspect about offering his opinions on everything that Charlie, but the topics that are off limits for Buffett at a Berkshire shareholder’s meeting have not been tightly defined to those three topics in the past. When Charlie does express his opinion on a subject like modern academia he does not have money on the table and the Circle of Competence concept does not provide the same restraining effect as when money is involved.

Staying within a Circle of Competence is obviously not rocket science, but it is hard to do when you meet a slick promoter who is highly skilled at telling stories.  This is a case where emotional intelligence, which is very different than IQ, becomes critically important.  Humans love stories since it causes them to suspend disbelief.  Madoff and Ken Lay were  story tellers.  I put this problem in the form of a tweet recently:

“Promoters know muppets love narrative & actual facts detract from desired state of suspended disbelief. Circle of Competence…”

Munger’s advice on why staying within your Circle of Competence is important is direct as is usual:

 “You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge.  And you’ve got to play within your own Circle of Competence.”  http://www.ritholtz.com/blog/2012/02/a-lesson-on-elementary-worldly-wisdom-as-it-relates-to-investment-management-business/

Too many investors confuse familiarity with competence.   For example, that a given person may fly on airlines a lot does not mean that they understand the airline industry well enough to be competent as an investor in that industry.  Using Facebook, that does not make you qualified to invested in a social media start up.  If you have not taken a deep dive into the business of a company and its value chain/industry, and you nevertheless decide to invest in that company, you are asking for trouble.

It’s important to ask yourself whether you have a personality that fits with the qualities needed to make your own investment decisions that involve individual stocks bonds and other investments.   Do you enjoy reading extensively about companies you may invest in and their industries? Are you going to be happy spending hours each month doing so?  Or would you rather spend that time playing golf or watching sports on TV?  Do you find doing the work to make yourself a wise investor is fun?  Do you spend more time researching a refrigerator than the stocks you buy?  Is doing due diligence on an investment the sort of thing that makes you genuinely happy.  Or is it like a root canal?

There are some people who know very well how to stay within the Circle of Competence and the Berkshire CEO list has way more than its fair share of these people.  For example, Buffett cites Rose Blumkin of Furniture Mart as a person who fully understands the dimensions of her capabilities:

“[If] you got about two inches outside the perimeter of her Circle of Competence, she didn’t even talk about it.  She knew exactly what she was good at, and she had no desire to kid herself about those things.”  (Snowball at  495).

Knowing the boundaries of your Circle of Competence is critically important.  In Munger’s opinion, if you have to ask the question whether something is within your Circle of Competence, you have already answered your question.  He feels that the answer should be obvious:

“If you have competence, you pretty much know its boundaries already. To ask the question [of whether you are past the boundary] is to answer it.”  http://www.poorcharliesalmanack.com/pdf/page53.pd f

Buffett talks about that fact that knowing where the perimeter of your Circle of Competence may be is far more important than the size of your circle.  If you are only competent in spots and stay in those spots you can do just fine, argues Munger.

Overconfidence, Over-optimism and other Dysfunctional Heuristics

Why do people invest outside their Circle of Competence?  The answer can be found in what Charlie calls dysfunctional “mental models” which will be discussed in detail in a later post in this series on Munger’s Methods.  As a taste of that what Munger is talking about, I can’t resist inserting on quotation which describes just one dysfunctional overconfidence heuristic:

“In the 5th century B. C. Demosthenes noted that: “What a man wishes, he will believe.” And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert’s public assessment is that he is above average, no matter what is the evidence to the contrary.”  http://72.14.203.104/search?q=cache:mgSaxC3O1IoJ:www.philanthropyroundtable.org/magazines/1999/march/munger.html+Berkshire+Hathaway%27s+vice+chairman+shreds+the+conventional+wisdom+on+foundation+investing&hl=en&gl=us&ct=clnk&cd=1

Berkshire itself has sometimes failed to properly apply the Circle of Competence filter as has its portfolio companies.  As was explained in the first post in this series, Berkshire makes mistakes like everyone else.  Buffet arguably was out of his Circle of Competence in the 1960s when he bought the department stores and then bought Associated Cotton Shops which sold women’s dresses.  Dexter Shoes is another case where Berkshire wandered outside its Circle of Competence and was badly burned as a result

One example of a Berkshire portfolio straying from its Circle of Competence principle happened in the case of their most profitable insurance company according to Munger.

“[GEICO] got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses. All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there.”  http://ycombinator.com/munger.html

Munger himself may have fallen prey to this with his investment in BYD as was discussed in a previous post in this series.  Did Charlie really know enough about BYD for it to fall within his Circle of Competence?  How is BYD not a technology Company?  All Berkshire companies use technology, but BYD is trying to solve technology problems that are core to its business.  It can be argued in investing in BYD Charlie was just having a lot of fun in an exotic country and got carried away.

In using a Circle of Competence filter,  Munger is trying to invest only when he has an unfair advantage.  Otherwise, he wants to do nothing (which most people find very hard to do).

“The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much.” http://www.normanrentrop.de/de/gefunden/index_20602.html

In short, Charlie is looking for betting odds which are substantially in his favor when making an investment.  And when he finds such a situation, he bets big.  Otherwise he doesn’t bet.  It’s that simple.  A future post in this series on Munger’s Methods will deal with just that basic idea.

What is critical in following this approach is patience:

“We have this investment discipline of waiting for a fat pitch. If I was offered the chance to go into business where people would measure me against benchmarks, force me to be fully invested, crawl around looking over my shoulder, etc., I would hate it. I would regard it as putting me into shackles.” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3

Doing nothing is a very hard thing for most people to do.  People for some reason think there is a bonus of some sort for activity in investing when there most certainly is not.  In fact, there is a penalty on being overactive due to costs and expenses.

A Clear View of a Low Downside and a Big Upside

Munger does not like situations where there is a “close” investment decision  to make.

“There are a lot of things we pass on. We have three baskets:  in, out, and too tough… We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.”  http://www.fool.com/news/foth/2002/foth020515.htm

And certainly, Munger would not invest in anything with a big downside and little upside.  One of the best ways I have ever heard the idea behind Charlie’s philosophy expressed  was by the famed investor Sam Zell.

“Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” http://www.latimespressmen.com/showthread.php?p=1525

In terms of finance theory, what a smart investor is looking for is “optionality.” Nassim Taleb puts what the smart investor is looking for in this way: “Payoffs [which] follow a power law type of statistical distribution, with big, near unlimited upside but because of optionality, limited downside.” Venture capitalists who are “antifragile” benefit from optionality. Investment  bankers, who are “fragile” still are able to do this by being too big to fail and therefore socializing the big downside tail risk (i.e., get the taxpayers to pick up the losses from tail risk).

Charlie and Buffett want the financial upside to be big and clear enough that they can do the math in their heads.  Munger said at a Berkshire meeting once:

“Warren talks about these discounted cash flows. I’ve never seen him do one.”  [“It’s true,” replied Buffett. “If (the value of a company) doesn’t just scream out at you, it’s too close.”] 1996 Berkshire Hathaway Annual Meeting http://www.ndir.com/SI/email/q403.shtml

Of course, Buffett and Munger can do more mathematics in their heads that an average person can do on a calculator, but the point remains.  Munger and Buffett want the mentally computable math to be overpoweringly clear and positive.  Bill Gates has said on this point:

“… being good with numbers doesn’t necessarily correlate with being a good investor. Warren doesn’t outperform other investors because he computes odds better. That’s not it at all. Warren never makes an investment where the difference between doing it and not doing it relies on the second digit of computation. He doesn’t invest–take a swing of the bat–unless the opportunity appears unbelievably good.”  http://money.cnn.com/magazines/fortune/fortune_archive/1996/02/05/207334/index.htm

Technology Investments and the Circle of Competence

The technology sector is one area which Munger and Buffett have avoided since they feel they don’t understand the business well enough to predict where it will be many years down the road.  Munger received his first taste in the technology business when he bought into an oscilloscope company early in his investing career.  His top scientist was hired away by a venture capitalist and then magnetic tape came along and made things even worse.  Charlie has said the entire experience nearly made him “go broke.”

Munger’s reluctance to invest in the technology sector is not a new phenomenon:

“Warren and I don’t feel like we have any great advantage in the high-tech sector.  In fact, we feel like we’re at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies. Again, that is a very, very powerful idea. Every person is going to have a Circle of Competence. And it’s going to be very hard to advance that circle. If I had to make my living as a musician – I can’t even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.” http://ycombinator.com/munger.html

Berkshire recently bought a significant stake in IBM, but in that case the company has really transitioned from a technology company to a provider of services.   Munger has said that “IBM is easier to understand than Google or Apple.  It is a bit ironic that Berkshire invested in IBM given that Charlie said in 1994:

“In terms of blowing it, IBM is some example. Those were brilliant, disciplined people. But there was enough turmoil in technological change that IBM got bounced off the wave after “surfing” successfully for 60 years. And that was some collapse—an object lesson in the difficulties of technology and one of the reasons why Buffett and Munger don’t like technology very much. We don’t think we’re any good at it, and strange things can happen.”   http://ycombinator.com/munger.html

Munger’s personal decision regarding does not mean that the technology sector is not right for other people who do have a Circle of Competence that includes technology.  When asked recently about where they would start their career over again if they were just starting out today both Munger and Buffett answered: technology (one of them added energy as an alternative).

Technology presents additional challenges since uncertainty is high and the speed of innovation faster.     Buffett has said: “Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.”  In my view an investor can cope with that difference by being careful about his or her Circle of Competence within technology. To know a lot about graphics chips is not necessarily to know much about wireless data for example.   To think otherwise is to tempt fate.  As Clint Eastwood asked in the movie Dirty Harry if you break the Circle of Competence rule:   “You’ve got to ask yourself one question:  Do I feel lucky? Well, do ya, punk?”

Learn Continuously:  Read, Read, Read

“You don’t have to pee on an electric fence to learn not to do it” said Munger on one occasion.  At the most recent Berkshire meeting he quipped: “Learning from other people’s mistakes is much more pleasant.  The best way to do this is simple:  When in doubt, read so you can learn vicariously.  Charlie loves to talk about the importance of reading:

“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”  http://www.quoteswise.com/charlie-munger-quotes-2.html

We read a lot.  I don’t know anyone who’s wise who doesn’t read a lot.”  http://www.tilsonfunds.com/brkmtg04notes.doc

“Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.”  http://www.valuewalk.com/charlie-munger-page/

The other related point is: success is a lousy teacher.  Sometimes what seems like success was mostly luck. On that I suggest you read Mauboussin’s book The Success Equation .  http://www.amazon.com/Success-Equation-Untangling-Business-Investing/dp/1422184234/ref=la_B001HCX42G_1_1?ie=UTF8&qid=1354820111&sr=1-1

The next post in this series on 25IQ is about Munger’s Methods:  Charlie Munger on Management With Talent and Integrity (The Third Essential Filter)

• Charlie Munger on Moats (First of the Four Essential Filters)
• Charlie Munger on Management with Talent and Integrity (The Third Essential Filter)

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