Good Investing Is Knowing Where Your Smarts Stop

At Berkshire Hathaway's 2023 annual meeting in Omaha, with about 40,000 people gathered to ask questions, Charlie Munger, the investor who built Berkshire alongside Warren Buffett, was talking about why most investors own too many stocks.

University finance classes teach that broad diversification is mandatory, a notion Munger had just called an insane idea. If you have only three good opportunities, he argued, you should back your best ideas rather than dilute them with ones you barely understand. As Munger put it, some people "can't tell their best ideas from their worst," and they convince themselves a holding is better than it is.

Then he offered his alternative: "We're not so smart, but we kinda know where the edge of our smartness is."

The idea is known as the circle of competence. Because there are thousands of public companies to choose from, an investor can ignore almost everything and still find a few good ideas. The edge goes to whoever sticks to the industries and business models he understands better than most investors.

Buffett, his longtime partner, gave the lived example. Buffett says, "I don't understand the phone at all," referring to the iPhone. What he does understand is consumer behavior, and how fiercely people stay loyal to a product they love.

That focus first paid off after they bought See's Candy in 1972, when they watched a company selling what looked like an easily copied box of chocolates use its brand to raise prices year after year. It later shaped Apple, their biggest investment to date. They did not need to understand the phone, only the customer, and that was safely inside their circle.