Investing Concepts 101: Circle of Competence

If you’ve read any of the other posts here on WiredInvestors, you’ve probably realized that Warren Buffett is a huge influence on our overall investing philosophy. That shouldn’t be surprising, considering the fact that the Oracle of Omaha is quite possibly the greatest investor of all time (if not, he’s definitely in the top five).

Before we get to today’s post, we want to thank Karen from MakinTheBacon for allowing us to guest post on her great personal finance blog. We wrote an article about 6 Surprising Ways you can Invest Your Money – go check that out, it’s an interesting read.

Also, we were recently featured on a Business.com article, so check that out too.

Anyways, on to the topic at hand.

Today, we’re going to talk a little about one of Buffett’s core teachings – a concept called the Circle of Competence.

What is the Circle of Competence?

The Circle of Competence is a secret society that Buffett is a part of – they think of the rest of society as more or less incompetent, and their aim is to take over the world in order to pursue a Utopian future.

Just kidding.

The idea of a circle of competence is one that is often mentioned by Buffett – here is a quote from the man himself where he describes what he means:

“Intelligent investing is not complex, though that is far from saying that it is easy. 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.”

In short, Buffett is telling you to stick to what you know.

You’re probably thinking: That doesn’t make sense! You run a website where you’re trying to teach people about an entirely new type of investing that most people have never heard of, and then you’re telling people to stick to what they know? What gives?

Well, sticking to what you know is certainly important. However, if everyone always stuck to what they knew, nobody would know anything. Warren Buffett wasn’t born with the ability to value companies or read accounting statements. He had to learn all these things.

Most people are woefully undereducated when it comes to managing they’re money. The number of people who buy into the stock market without knowing basic investing concepts is mind-boggling. The point here is not to shy away from learning new things or to put yourself in same kind of intellectual cage. The point that Buffett is trying to make is that it is essential to know what you know, and more importantly, know what you don’t know.

Ever had a conversation where the person you’re talking to is pretending to be an expert on a something when it’s clear that he/she doesn’t actually have a firm grasp on the subject at hand? This is what we want to avoid. The goal here is to be able to identify where you lack knowledge, and to be able to admit that you have faults – if not to other people, then at least to yourself.

One well known fact about Buffett is that in the heyday of the Tech Bubble 1.0 (we’re probably in 2.0 right now), he refused to invest in the burgeoning tech companies that were making everybody else rich. He consistently stated that he didn’t understand the tech industry, and because of this, he was going to stay out of it completely. As a consequence of this, when the tech bubble burst, millions of people lost fortunes overnight, while Buffett walked away relatively unscathed. This is an example of a man who knows his circle of competence – even in an environment where others were virtually printing money, he refused to participate because he didn’t understand how it all worked.

The idea of knowing your circle of competence absolutely essential to any investor – without it, you’re bound to invest your money into something you don’t really understand, and will probably lose money as a result.

Expanding Your Circle

Expanding Circle of Competence

However, there is another aspect to this idea of knowing your circle of competence – when you have the time, and when you’re willing to put in the effort, you can expand your circle.

This is exactly what Buffett has done. During the bubble, in a time where there was huge pressure on him to invest in tech stocks, he refused. On the other hand, over the years, Buffett has in fact invested in a handful of tech companies – he currently holds a pretty large position in IBM.

The difference between the Oracle and folks who lost their shirts in the tech bubble is this – he took the time to really learn about the industry. He didn’t jump in with a hole in his knowledge – he bided his time, waited until he really felt he had a good grasp on the industries that IBM is in, and only then did he put his money in. He’s not working on anybody else’s schedule – he marches to the beat of his own drum, and he only invests in something when he’s confident that he understands it.

Applying the Circle of Competence to Buying Websites

The first thing that you should take away from this lesson from the world’s greatest investor is that you should understand something well before you invest your money in it. When it comes to investing in websites, that means having a good grasp on the entire website buying process, from prospecting opportunities, to doing due diligence, and all the way through to managing/maintaining a website.

Now, do you have to be an expert on all the above? No, probably not. When investing in stocks, it is possible to start off with a simulated portfolio, but because website revenues and traffic numbers aren’t public, you can’t really simulate a portfolio of websites.

Both the buying process and website ownership are things that you probably can’t fully understand until you have some firsthand experience, so on some level you just have to jump in and see if you sink or swim. Just remember that your first website purchase is more of a learning experience and not just an investment. I also recommend that you do the following when planning your first investment into websites:

  • Start small, and only use an amount of money that you’re comfortable with losing, especially if you’re buying your first site.
  • Go in with low expectations, and treat your initial investment as a kind tuition or test run. Chances are you’re not going to hit it out of the park on your first swing. Treat the knowledge you gain from your first investment as a portion of your ROI.
  • Understand that when you’re consciously trying to expand your circle of competence, you’re bound to make a few mistakes. Don’t beat yourself up about it – just learn the appropriate lesson and move on.
  • I stress this over and over on this site – if you don’t have the time or aren’t inclined to put in the effort, then forget about this website investing stuff and go buy some passive index funds. Do what Buffett did with tech stocks – if you don’t understand it, and you’re not willing or you’re unable to fill the gaps in your knowledge, then just refuse to participate. You’ll be better off for it.

For more experienced website investors, the circle of competence idea applies even more. First time buyers are unlikely to believe that they know what they’re doing. On the other hand, people who have some online business experience or have bought sites in the past might trick themselves into believing that they know a lot.

Here’s An Example

Someone with experience with SEO and ranking websites buys a site that generates most of its traffic from social channels. This person expects to able to maintain and improve the traffic levels of the site, but doesn’t fully understand the social network being used to drive traffic (Pinterest) and as such, has a hard time boosting the traffic levels significantly. While his experience in SEO helps a little, the results are mediocre because the site is mostly images and curated content (and duplicate content doesn’t tend to do well in google).

Luckily, this person is able to maintain the earnings on the site and eventually sell it for profit – if he hadn’t been able to maintain the traffic levels through social channels, he could’ve lost money on the site. Fortunately, his broader knowledge of online business helped him do alright, but even he admits that the investment was an ideal one.

If this example sounds familiar to you, it’s because the person we’re talking about is Spencer Hawes – he discussed his investment in a Pinterest site as a case study here. At the end of his post, Spencer says this: Now I know that I should stick with the types of sites that I’m more familiar with.” – this quote perfectly captures the idea of sticking to your circle of competence.

Now, if Spencer’s goal here was to learn more about driving traffic through Pinterest to expand his circle of competence, then that’s perfectly fine. It’s important to keep learning, especially in the online business space where things can change in the blink of an eye. The key is to be able to separate the two – in some cases, you’re looking for the best returns possible, and in other cases you’re making a conscious effort to expand your skillset. You’ll get the best results both in terms of investment returns and in learning if you never confuse to two.

Get Familiar with Your Own Circle

Range of Skills Circle of Competence

Now, here’s a (probably incomplete) breakdown of the skills that relate to website investing. Go through it and think carefully about each one and put yourself in one of three categories – beginner, intermediate, and expert:

  • Prospecting/finding sites to buy
  • Due Diligence: Traffic Analysis
  • Due Diligence: Monetization Analysis
  • Due Diligence: Domain Value (Power & Brandability)
  • Buy Side Transaction Process
  • Traffic: On Page SEO
  • Traffic: White Hat SEO Linkbuilding
  • Traffic: Black/Grey Hat SEO Linkbuilding
  • Traffic: (FB, Twitter, Pinterest, LinkedIn etc.)
  • Traffic: Viral (Reddit, Imgur etc.)
  • Traffic: Paid (Adwords, FB Ads)
  • Conversion: Adsense
  • Conversion: Amazon Affiliates
  • Conversion: Other Affiliates
  • Conversions: Ecommerce
  • Conversions: Single Product (SAAS, EBook, etc)
  • Content Creation
  • Product Creation (Ebooks, Courses, Physical Products)
  • Managing Writers/VAs

The more you know your strengths and limitations, and the better you understand your own circle of competence, the more successful you’ll be at both acquiring new skills and investing in new websites.

 

 

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