Back to the Basics: Circle of Competence

What It Covers

Stephen Morris and Andrew Sather break down the circle of competence framework for stock picking — defining it as knowing both what you understand and what you do not, using real examples like Zoetis, Eli Lilly, Tesla, and EV stocks to illustrate how misapplying this concept leads to costly investing mistakes.

Key Questions Answered

• •Circle of Competence Definition: The framework has two equally weighted components: knowing what you understand AND knowing what you do not. Most investing mistakes stem from the second part — investors overestimate familiarity with a business because they recognize its name or use its products, without understanding how it actually generates revenue or sustains competitive advantage.
• •Consumer Knowledge vs. Business Knowledge: Recognizing a brand does not equal understanding its business model. Kroger appears to be a grocery chain, but its real revenue driver is owned real estate — similar to McDonald's. Before investing, verify you can explain how the company actually makes money, not just what product or service it sells to consumers.
• •Three-Circle Mapping Method: Draw three concentric circles on paper. The inner circle requires answering five questions: Can you explain the business in 60 seconds, who pays them, their finances, their moat, and what could kill them overnight? Between circles one and two is safe territory. Outside circle two signals insufficient understanding requiring more research or avoidance.
• •Narrative Trap Avoidance: Market narratives — EV in 2020, marijuana stocks around 2018, AI currently — inflate stock prices temporarily but collapse without warning. Rivian stock sits 87% below its peak. Buying into sector hype without a genuine circle of competence means holding positions through severe drawdowns with no analytical framework to evaluate recovery prospects.
• •Portfolio Sizing Scales With Competence: Position size should directly reflect depth of understanding. A 25% portfolio allocation demands near-expert-level knowledge of the business. Spreading across 100 companies requires far less individual depth. Andrew reduced a 10% Starbucks position after recognizing insufficient conviction, reallocating half into Alphabet — a company within his stronger circle.