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Lessons from Warren Buffett - LXIV

22 October 2016

Last time, when we examined Warren Buffett's 2012 letter to shareholders, we understood bargain stocks do not always translate into wonderful investments. We also learned how a business with terrific economics can be a bad investment.

With those lessons in mind, we now move on to Buffett's 2013 letter. In this letter, Buffett explains the importance of knowing your limitations in the game of investing. As always, he packs this wisdom in few words. He writes:

You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits, respond with a quick 'no'.

Do you imagine value investors as all-knowing number-crunching machines? Do you think of them as extraordinary supermen who have an in-depth understanding of everything in the world of business? If so, you are grossly mistaken.

What is the secret to their success then? It has to do with what Buffett calls 'circle of competence'. Your 'circle of competence' is all the businesses you are familiar with and thoroughly understand.

Buffett likes to keep it simple. Some of his biggest investments have been in companies whose products he's known since childhood. When he was six, Buffett went door to door selling Coca-Cola and Wrigley's chewing gum. When he was in high school, he delivered newspapers.

Investing in what you know is one thing. But the other side of this coin is just as important but often overlooked. And it's where value investors like Buffett have a significant edge. Value investors have a very clear understanding of what they do not know. They avoid investing in businesses that they cannot understand.

Buffett is known to be quite disciplined in this regard. It famously kept him from investing in technology stocks. While the world rode the tech bubble of the 1990s and tech stocks soared to incredible heights, Buffett maintained his discipline. He did not invest a single penny into tech stocks. He argued that tech stocks were outside his circle of competence and he wasn't comfortable owning them. So while he missed some big opportunities, he also avoided the extreme losses that many suffered when the tech bubble burst.

The lesson is this: Know your limitations and play within your circle of competence in the game of investing. If you find a company within your circle of competence, you buy it if it is selling at the right price and has a durable moat.

Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly. - Charlie Munger

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