Find your circle of competence. Buy what you know. These are two fantastic pieces of advice from some of the best investors of our time, Warren Buffett and Peter Lynch. It’s easier to get overwhelmed by all the choices we have. It’s the same for the stock market. There are thousands upon thousands of different investment choices available to us. It’s both the blessing and the curse of living in the 21st century. Not only are there all those choices out there, there is a whole industry of people telling us how we should be investing. And that advice usually changes ever 6 months or so.
Why is that? The majority of time the people giving the advice make money on transaction fees. So it is in their financial interest for you to be changing up your investments as frequently as possible. The vast majority of the time that is not what you should be doing. Timing the market is hard. By building a high quality income portfolio and stuffing it with companies you are relatively certain will be around 10 , 20, even 50 years from now you can make investing easier. Once you buy you can sit back, click the re-invest dividends button, and watch your returns pile up over the years. No trading necessary.
Qui Bono? – is something you should always be asking yourself. It means “Who benefits?” I promise you 99.9% of the time when someone has an “incredible opportunity” for you, they will be the ones benefiting. Brokerages make money off of you when you trade. Hence they would like you to trade more, even if that is not in your long-term best interest.
By building a circle of competence, you can have confidence to rely on your own judgment when it comes to investments. It makes it much easier to ignore the next big thing that “everyone” is making money on.
How do you build a circle of competence? First start with what you know. The industry you work in is a great start. You likely have a pretty good idea about the economics of the industry you work it. What needs to happen for your company to make money? If the answer is the sun needs to come up tomorrow, you have probably found a good starting place. If you are in a cut-throat industry where margins are razor-slim and a whole lot of things need to go right in order to turn a profit, maybe start somewhere else. Knowing what not to invest in is just as important as knowing what to invest in.
The next place to look is the businesses and goods you see around you every day. Notice that one chain that always has lines out the door? Maybe a good place to start doing some research. How about that hot new brand that is flying off of the grocery store shelves? Another potential opportunity. Or maybe you notice a lot of new buildings are going up near where you live and they all have signs saying “financed by your friendly regional bank.” Something else you can look into.
One key piece about your circle of competence is you should understand those businesses cold. If you aren’t able to simply explain the business model to a neighbor, friend, or relative, you probably don’t understand it. Or it is a red flag because the business model is too complicated.
If you don’t understand what you are invested in, how can you have the conviction to stay with it when the price goes down? If I am in a mystery fund and the value of the fund went from $10,000 to $7,000, I’d start to panic a bit. Even though I know a 30% loss is well with the realm of possibility for any given stock. And that is what will get you in trouble. When you do sell at a 30% loss, you are booking those losses, making them permanent. That is the #1 reason retail investors (average folks like you and me) on a whole underperform index funds over time. It’s because they sell low.
The difference is, when you understand the business and the value of your investment drops from $10,000 to $7,000, you are in a place to make an informed decision. Has anything changed with the quality of the underlying business? That really is the crucial question. If you know enough about the business to answer that question, it makes it a lot easier to ride out the storm of any short-term performance issues.
In reality some of the best times you can buy companies with strong underlying business models is after some sort of short-term performance hit. For medical companies those can be lawsuits, for international companies it can be currency headwinds. Every industry will have its own version. If you know what those are and know companies will weather the storm, you can get ahead of the game. If instead of selling when your shares dropped 30%, you realize that over the next 4-5 years the company will be as strong as ever and growing earnings as fast as ever, you can get ahead of the game by buying more at a discount.
All that takes is having conviction and staying inside your circle of competence.