Summer’s full swing has kept me away from this blog, but luckily it gave me some time to think more deeply about a number of ideas and topics.
One of those is: What tempts us to go beyond our circle of competence?
Buffett constantly warns investors against going outside their circle of competence since doing so would mean treading into industries/areas where one would not have an edge. Yet, despite this constant exhortation and strong evidence that sticking to one’s own domain of expertise is a very good strategy, very few seem to follow that sage advice (including myself on a number of occasions in the past – I certainly hope I won’t ever experience another JCP).
Although I am speaking from an investing context, this advice is clearly useful as a general life strategy. I often chuckle when the average Joe wants to teach their doctor about how to deal with certain ailments…
So I gave this question a good think while on a walk.
And then I realized that it’s not so much that we, humans, are terrible at remembering good advice. It’s that the cards are stacked against us.
The investing market has become far more crowded in recent years, and there are far too many bright people chasing similar ideas. In order to truly make a lot money, two things need to happen: 1) You are right about something that nearly everyone thinks is wrong (contrarian), or 2) You are right about something before anyone has even heard about it. And unfortunately, both of these things naturally push us outside of our circle of competence.
Let’s consider the first case where we find ourselves amongst a small minority view. If the opposition is equally smart (and good looking) and working purely within their circle of competence, it is highly unlikely that we, as a minority, would have the right view and also be within our circle of competence. It is highly unlikely in such a situation that both longs and shorts are within their own circle of competence but then come to different conclusions from the facts at hand. These are battleground stocks (like Ackman short Herbalife vs Icahn long Herbalife) and best avoided…clearly one of them is outside their circle of competence. Where the investor base is generally “smart”, the consensus probably holds the right view, and as a result the opportunity for alpha is low.
Let’s consider the second case where we find a brilliant new opportunity (a fine gem!) before anyone else has heard about it. These situations usually only come about from two pools of stocks: 1) Small caps, and 2) New companies. Assuming we put in the effort to sift through the long tail of small caps and new companies, we should be able to generate alpha. But here we also find that the world constantly conspires against us to push us outside of our circle of competence! These companies are often in new industries or with untested business models. Though we may deem ourselves to be within our circle of competence, the potential for misjudgment is higher.
In some prior time, investing was a much simpler endeavor, and sticking within one’s circle of competence was likely a much easier task to accomplish. Generating alpha is always easier when “investors” do not understand the basic tenets of fundamental investing. Now the market is crowded, and it seems to me that sophisticated investors are increasingly pushed outside their circle of competence in order to achieve alpha.
What a tough cookie.