VR Logo

Avoid the doughnut of incompetence

Knowing what to avoid is an important part of the secret of success

Avoid the doughnut of incompetence

Do you know what Farnam Street is? It's an online publication that is named after the street on which Berkshire Hathaway's headquarters is located in the small city of Omaha in the United States. The Farnam Street website (fs.blog) describes itself as 'Brain Food'. It's not solely dedicated to investing or to Warren Buffett even though anyone who reads it will notice a kind of a connection, a commonality of themes between the ideas on the blog and the way Buffett and his deputy approach investments.

One of such most interesting themes is that of 'circle of competence'. On the Farnam Street blog, there is a fascinating story about a baseball player named Ted Williams who the blog says was the greatest hitter ever in that game. I know nothing about baseball so bear with me here. This man succeeded in hitting the ball 40 percent of the time which is apparently exceptional in that sport. Using an interesting diagram, the article shows the key to Williams' success in what he did not attempt to hit. In terms of where the balls came (roughly like line and length in cricket, as far as I can make out), he knew where his zone of success was and tried to avoid everything outside that.

This zone was his 'circle of competence'. Outside that, was what one might call the 'doughnut of incompetence', which is my phrase to describe whatever lies outside the circle. It's good to have as large a circle and as small a doughnut as possible, but the important thing is to know where the boundary lies and stay within it. Buffett and Munger have famously never dabbled much with technology stocks. They now have a huge holding in Apple but invested in the stock only when it effectively became a luxury consumer durables company. Historically, people have said that the pair misjudged the growth of tech.

Munger has an amusing incident to narrate from the beginning of his career. One of the earliest stocks he bought was from William Miller Instruments, a company whose founder had invented a better way of recording sound, something like an improved wax cylinder. He thought that it was going to take over all recording technology and Munger thought so too. However, someone else, around the same time, invented the magnetic tape. Tape was so superior that the company that Munger had invested in sold just three instruments. The entire investment was a write-off.

The normal reaction to this would have been to learn more about each technology and thus predict better. But no, that was not Munger's conclusion. Instead he decided that changing technologies were something to be avoided. If you have two things to invest in, one you understand and the other you cannot, what is the point of investing in the one you do not? 75 years have gone by since then, but this idea of staying within one's 'circle of competence' has served Munger and Buffett well. As he says, "I try to avoid being stupid. I'm not trying to succeed in my too-hard pile. The single most important thing is to know where you are competent and where you aren't. The human mind tries to make you believe you are smarter than you are. Rub your nose in your mistakes."

That's a hard thing to do - rub your own nose in your mistakes, but it's one of the secrets of success. Most of us, when our investments go wrong, try to justify why we were not actually to blame, that something unforeseen happened.

Of course, saying that one should not stray into the doughnut of incompetence is easy, doing it might be harder. When we start investing, few of us know anything about anything at all. Given the limits of one's life experiences, the circle of competence is more like a dot. So how does one begin? The obvious - and very workable - answer is mutual funds, supplemented by a self-conscious effort to acquire knowledge. The statement 'I don't know X' should never be acceptable, instead, it has to be 'I don't know X yet'.