Warren Buffett and right-hand man Charlie Munger have an unrivalled investment record. Their success, judged on a combination of longevity and returns, is second to none. As such, their words of wisdom are worth listening to.
Both men have been free with their advice on all manner of subjects over the years. But I see one fundamental piece of investment advice stressed repeatedly. Whether we’re novices or older hands, I think this advice can help make us better — and richer — investors.
Circle of competence
You don’t have to be a financial know-it-all to get rich from the stock market. Indeed, Warren Buffett has said: “To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these.”
According to Charlie Munger: “Knowing what you don’t know is more useful than being brilliant.” Buffett and Munger put their success down to sticking to their “circle of competence.”
What is a circle of competence? Well, each of us, thanks to study, work and play, has acquired useful knowledge in certain areas. Some areas are readily understood by most of us, and some require a high degree of specialised understanding. The sum of each individual’s knowledge is his or her circle of competence.
Know your boundaries
According to Warren Buffett: “You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
Even within your circle of competence you’ll make some investing mistakes. Venturing outside it is stupid, because you’re almost guaranteed to make more — and more costly — errors.
You can extend your circle of competence incrementally over time. Charlie Munger recommends: “Spend each day trying to be a little wiser than you were when you woke up.” But it’s essential to always know where the boundaries of your circle of competence stand.
Keep it simple
According to Munger: “One of the greatest ways to avoid trouble is to keep it simple.”
Buffett has put flesh on the bones: “Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.”
Keep it simple. As Buffett has put it: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”
Summing up
You don’t need to be a financial wizard to be successful in the stock market. From long experience, Warren Buffett and Charlie Munger reckon the key to getting rich is to stick to your circle of competence and keep it simple.
I’ll leave the last word to Munger: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
