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Why it’s important to stay in your circle of competence

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One of Warren Buffett’s favourite ways of avoiding losing money is sticking to his ‘circle of competence’.

He described it as such: “What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. 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.”

If you don’t understand how a business runs, what affects its revenue, what the industry dynamics are or what the risks are how are you supposed to decide if it’s a good investment. If you don’t know why you’re buying into a business, how would you know when to sell?

What would happen if a competitor releases a product, would you know if that’s a problem or not?

If your company makes an acquisition or is spending serious capital on developing something, how are you supposed to evaluate if that’s a good move or not?

Of course, you don’t need to know exactly how Xero Limited’s (ASX: XRO) software is developed to understand how good its proposition is for business owners and accountants.

You don’t need to understand the latest food-growing techniques that Costa Group Holdings Ltd (ASX: CGC) is using to know it’s benefiting from a growing national and global population.

It is important to understand the market pricing power of REA Group Limited (ASX: REA), but you don’t need to be a website developer to get a good grip on the business.

However, I personally don’t fully understand Nanosonics Ltd (ASX: NAN) so I’m avoiding it. I’m not personally sure about the opportunity with Nearmap Ltd (ASX: NEA), so it’s staying out of my portfolio. Corporate Travel Management Ltd (ASX: CTD) may be a great business, but I know nothing of the industry (yet), so I will remain on the sidelines.

Foolish takeaway

Sticking to your circle of competence could mean avoiding blow-ups like GetSwift Ltd (ASX: GSW) and Big Un Ltd (ASX: BIG), even if it means missing the occasional star as well.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Corporate Travel Management Limited, COSTA GRP FPO, Nanosonics Limited, and Nearmap Ltd. The Motley Fool Australia owns shares of Xero. The Motley Fool Australia has recommended REA Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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