The financial market turmoil of late 2008 has made a large amount of headlines and wiped out a lot of wealth (paper or otherwise). Being involved in the market during this last year has taught me a lot of lessons about investing, markets, and more importantly, myself. These series of blog entries are my attempt to share my positive and negative experiences. I try not to have regrets, and if I do, I try to learn from them. I hope that my readers find these interesting and useful for their own investing ventures.
Why "Circle of Competence" Matters
I have been lucky (I believe) to have started to study the discipline of Value Investing last couple years, but didn't really take much action because valuations were too high. Consequently, this meant that I had a large percentage of my savings in liquid or semi-liquid form.
I decided to follow the value investing strategy for my personal portfolio starting January, 1 2008. I created valuation models for myself and screened various stocks for typical signs of value. With Graham and Buffett as my guides, I went through a lot of companies' annual reports and balance sheets.
At the beginning of 2008, it was believed that we were well within the credit crisis, and the banks were selling for major discounts to what they traded at before the U.S. subprime housing bubble burst.
Since my screens kept on revealing mostly financial companies, and they were selling at historically attractive valuations; I was greatly tempted by them. I recalled Buffett's famous maxim, "Be fearful when others are greedy; and be greedy when others are fearful". It was obvious that the fear of financial institutions' solvency was rampant in the market, and I held firm the belief that well managed banks would get out of subprime mess and the market sell off is discounting more than it needs to.
In all my greediness, I forgot one of the most important criteria that Buffett sets out for his investment choices. The criterion of Circle of Competence; he does not recommend investing into businesses that he does not understand. If it is too complicated to understand, then he suggests, that one should look elsewhere.
I ventured out of my "circle of competence" and invested in an international bank, namely Deutsche Bank (DB). From my research, the bank appeared to have intelligent and responsible management, had called for greater transparency from their peers, increased their dividend in spite of being in the crisis, and didn't have much writedowns at all during 2007.
I still hold this stock, but I have a paper loss of over 70%! When I look at that, it does bother me, but that loss reminds me that I ventured outside my circle of competence. I still think that this a sensible investment (but not at the price I bought it at), but it is very hard to know where that bottom is. For this particular stock, due to my lack of understanding of their business, I obviously couldn't set a decent fair value. Even after applying a large margin of safety, my concluded valuation numbers were way off.
Lesson learned: Circle of Competence matters-- it matters a whole lot.
