Know The Ledge ( aka. “Circle of Competence”)
** 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.
** If we have strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.
** All I want to know is where I’m going to die, so I’ll never go there.
** If you play games where other people have the aptitudes and you don’t, you’re going to lose…You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.
** It is remarkable how much long-term advantage [we] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.
** It’s not a competency if you don’t know the edge of it.
— Warren Buffett & Charlie Munger
This is lesson #5 in our “Startup Buffettology” series.
The latter four quotes actually come from Charlie Munger, Buffett’s long-time partner and alter ego, who happens to be every bit as sharp as Warren.
For the entrepreneur, “expert of on every company” can read “expert on every type of customer” or “expert on every idea” or “expert on every market”.
The circle of competence concept is a very useful adjunct to our Rule #1 — you need to know what you don’t know as well as what you do know…”know” in this context meaning “understand much better than the vast majority of people”. To paraphrase Donald Rumsfeld, you need to identify the known-unknowns.
How does one find the ledge? Rule #1 gives some guidance. The final quote above also makes clear that if you don’t know what you don’t know (known-unknowns), then you aren’t yet “competent”.
Another useful tool is the idea of inversion. Munger is fond of making reference to a statement by the 19th century German mathematician Carl Jacobi: “Invert, always invert” (originally “man muss immer umkehren”).
Munger and Buffett often solve problems not by thinking along the lines of “What is the smart thing to do?”, but by asking “What is the stupid thing to do?”.
Another quote from Munger:
In other words if you want to help India, the question you should ask is not “how can I help India?”. You think “what’s doing the worst damage in India? What would automatically do the worst damage and how do I avoid it?” You’d think they are logically the same thing, but they’re not. Those of you who have mastered algebra know that inversion frequently will solve problems which nothing else will solve. And in life, unless you’re more gifted than Einstein, inversion will help you solve problems that you can’t solve in other ways.
The technique of inversion should be close to the heart of any entrepreneur. We entrepreneurs generally exist in a self-created bubble of optimism, and such mental models are great helps in bursting (or at least managing) that bubble.
The entrepreneur should ask “What would make this idea/business fail?” even more frequently than “What would make this idea/business succeed?”, and in answering that question honestly and in sufficient detail one should be able to identify areas where one’s knowledge is too weak to ensure success.
There are two extreme cases: if one cannot identify any significant ways in which the business can fail, one is probably incompetent. If one can identify too many ways then regardless of your competence level it’s probably going to turn out to be too complex. Remember Rule #2.
Generally entrepreneurs need to take an interest in risk management (a brief discussion can be found here). Large corporations like Shell have pioneered quite a few techniques in that area which, when rightsized for entrepreneurial use, are very good aids for identifying known-unknowns and treacherous waters.
One such “rightsizable” tool is scenario planning, which deserves its own series of posts. The thing with scenario planning is not so much the details of the scenarios themselves, but the entrepreneur’s ability to come up with three or four “axes” on which the scenarios will be built. If you cannot do this, you definitely don’t know enough about the subject area.
As a side note: scenario planning is one of many tools developed by “corporates” that are under-appreciated in startupland and amongst entrepreneurs…that topic also deserves another series of posts. Interestingly enough, in the chapter “Competitive Strategy in Emerging Industries” in his landmark book “Competitive Strategy”, Michael Porter alludes to scenario planning as a preferred forecasting tool.
There are some simpler checklist-type models popular in the corporate world that can readily be adopted for use by entrepreneurs in order to help identify the ledge/known-unknowns. The TECOP model is a good one (a good example starts on Page 8 of this file), as is PESTLE. These tools are good aids for quickly surfacing risk areas and with some creative application they can be used to map the boundaries of your competence.
Once you have identified the ledge, don’t go there. You don’t need to be a genius — just avoid being stupid!