TL;DR: Investing within your circle of competence means buying stocks only of companies you can evaluate: you understand the business model, the competition and the main risks. You admit where your knowledge ends and leave the rest alone, or invest there through a broadly diversified fund.
What can you expect?
- Time per week
- A few hours a week of research when selecting companies, less afterwards for follow-up.
- Starting capital
- No fixed minimum. With a small amount, diversifying across several companies is hard, so many investors use a broad fund for most and a few focused positions.
- Typical setbacks
- Your company falls despite your knowledge, you overestimate your understanding, or you miss a rising sector outside your circle.
- Costs
- Order costs, spread and currency costs on foreign stocks, and possibly costs for price data or research. Compare costs between brokers.
- Not suitable if…
- Not for anyone expecting certainty or quick profit, or without time for research.
How it works
The idea of the "circle of competence" is that you invest only in companies and sectors you genuinely understand: how they make money, what their competitive advantage is and what risks they face. Warren Buffett uses the term in his 1996 shareholder letter: you only need to be able to evaluate companies within your own circle of competence. The approach reduces the risk of investing on hype or guesswork, but does not remove risk: even companies you know well can fall sharply in value, and a small number of positions makes your portfolio less diversified. Educational information, not investment advice.
Core principles
- 1. Stay within areas you genuinely understand
- 2. Be honest about the limits of your knowledge
- 3. Avoid companies whose business model you cannot explain, however attractive they look
- 4. Widen your circle slowly through study, not through hype
Step-by- step plan
- 1
Map your knowledge
Write down which sectors you work in or know thoroughly, and which products and services you understand well.
- 2
List what you avoid
Write down sectors you do not invest in because you do not understand them. Review the list yearly.
- 3
Run the self-test per company
For each company answer the questions on business model, customers, competition, risks and figures. If you cannot answer them, do not invest in this company.
- 4
Set the maximum per position
Decide in advance how much you put at most into one company and what loss you can bear.
- 5
Review and widen slowly
Periodically review your reasoning and outcomes. If you want to widen your circle, study a sector for at least several months before investing.
In detail
What is a circle of competence?
Your circle of competence covers the companies and sectors you understand well enough to form your own judgement. A nurse knows healthcare better than most investors; an accountant can read annual accounts fluently. Buffett mentions it in his 1996 letter: you only need to be able to evaluate companies within your own circle of competence.
The question is not how large your circle is, but whether you are honest about where it ends.
A self-test for each company
Before buying, you can ask yourself these questions: How does the company make money? Who are the customers and why do they keep coming back? What is the competitive advantage and how durable is it? What risks exist in the coming years? Can you explain the above to someone with no background, without jargon? If you cannot answer several questions, the company is probably outside your circle. This is a tool, not a guarantee.
Being honest about your limits
Most people overestimate their knowledge. Reading a few articles about a sector does not make you an expert. Write down what you know and what you only think you know. Make a list of sectors you do not invest in. Check your reasoning afterwards: was your assessment right, or were you lucky?
Diversification and your circle
A small number of companies carries more risk than a broad fund. Many investors therefore combine a broadly diversified fund for most of their money with a limited number of focused positions within their circle. Cap the amount per position and watch correlation: companies in the same sector often move together.
- Basic knowledge of annual accounts
- Knowledge of one or more sectors
- Willingness to be honest about your limits
- Annual reports and quarterly figures
- Investment journal
- Broadly diversified fund for the remainder
- 01 You can explain in your own words how the company makes money
- 02 You understand who the customers and competitors are and what the main risks are
- 03 You have read the annual reports and figures
- 04 You have decided in advance how much you put at most into this company
- 01 The company's fundamentals deteriorate in a way that undermines your thesis
- 02 You discover you understood the company less well than you thought
- 03 You need the money for a goal set in advance
Worked example
This is a hypothetical example with simple numbers. It is not advice or an expectation.
You have €10,000 to invest. You decide:
- 60% in a broadly diversified fund: 0.60 x €10,000 = €6,000
- 40% in four companies within your circle, split equally: €4,000 / 4 = €1,000 per company (10% of your investments)
What if one company falls 40%? Loss: €1,000 x 0.40 = €400, which is €400 / €10,000 = 4% of your total.
What if all four fall 40%? Loss: €4,000 x 0.40 = €1,600 = 16% of your total. Within a single sector that happens faster than you think. The per-position limit (here 10%) limits such damage but does not prevent it. Costs and tax are not included.
Hypothetical example, not advice.
Work it out yourself
Risks and risk management
- Overestimation: many people think they know more than they do
- Concentration: few positions means one setback weighs heavily
- Price risk remains: even a well-understood company can fall sharply
- Missed opportunities outside your circle; that is a deliberate choice, not a mistake
- False sense of certainty: knowing a company does not predict its price
- Set a maximum per position (for example 10% of your investments)
- Invest the part outside your circle in a broadly diversified fund
- Keep an investment journal with your reasoning and check it later
- Compare costs and consult belastingdienst.nl on tax (such as box 3)
Learn the basics
Key takeaways
- It is not about the size of your circle, but about knowing where its edge lies.
- Understanding a company does not prevent price loss. It does reduce the chance of decisions you cannot justify.
- Combine focused positions with a broadly diversified fund for the rest, and cap the size per position.
- Widen your circle through study, not because a stock has just risen.
Frequently asked questions
How do I determine my circle of competence? +
Start with your work and daily life. For each company ask: how does it make money, what is the competitive advantage and what risks exist in the coming years? If you can answer that well, it is probably within your circle.
Can I widen my circle? +
Yes, but do it slowly. Study a new sector for at least several months, for example through annual reports and trade journals, before putting money into it.
How does this fit with diversification? +
Few companies means less diversification. Many investors therefore combine a broadly diversified fund for most of their money with a few focused positions, with a maximum per position.
Origin
Devised by / based on: Warren Buffett . Source: Berkshire Hathaway aandeelhoudersbrief 1996 (circle of competence)