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Why I’m sticking closer to my circle of competence right now

Warren Buffett has given the investment community many memorable quotes and lessons.

One of the most important pieces of advice, in my opinion, is sticking to your circle of competence. This simply means avoiding shares you don’t understand.

It’s very important to be able to evaluate the opportunities and risks of a business. You don’t need to be an expert in that field necessarily, but at least be able to get your head around the issues.

Shares like IMF Bentham Ltd (ASX: IMF), McMillan Shakespeare Limited (ASX: MMS) and Orica Ltd (ASX: ORI) may well be good businesses but I don’t think I can effectively evaluate them.

It’s easy enough to pick shares when the entire share market is going upwards. But, now that there are downward pressures and rising interest rates I think every investor needs to consider if holding some of the ‘riskier’ or less well-understood shares in their portfolio is a good idea.

Another Warren Buffett quote is very apt here: “Only when the tide goes out do you discover who’s been swimming naked.”

If your shares fall, can you tell if it’s just a valuation reduction or there is a serious problem for the company or its industry?

It’s best to know the answer before you buy the shares.

Foolish takeaway

Many investors are happy to talk up their shares or ideas. If you listened to every investor about why their share is a market-beating idea you’d think the entire ASX is the only place to be in the world.

Perhaps the opportunity is there, but so are the risks. We can’t lose sight of the risks or else we become far too complacent with our decisions and investment valuations.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. 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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