Circle of Competence Rule
Invest only inside the boundary of what you genuinely understand
- Difficulty
- Moderate
- Time to result
- ~ongoing to results
- Steps
- 4
- Confidence
- 97%
The Circle of Competence Rule is a decision boundary: proceed only when an investment falls within what you genuinely understand. Johnson stresses that the goal is not to make the circle as large as possible, but to know and respect its perimeter. The mechanism is protective humility. An investor first explains the product, its value drivers, and its risks. Any material inability to understand or value it places the opportunity outside the circle and triggers abstention rather than guesswork. Johnson connects the rule to complex mortgage-backed securities and to Warren Buffett's avoidance of late-1990s technology investments he did not understand. The rule converts the uncomfortable admission “I don't understand” into a disciplined risk-control action.
Origin
Johnson invokes Warren Buffett's circle of competence while reflecting on investment complexity and what he wished investors understood earlier.
Core principles
- 01The boundary of competence matters more than its size
- 02Not understanding an investment is a valid reason to abstain
- 03Complexity can conceal an inability to value a product
- 04Humility protects capital
How to run it
- 1
Explain the investment
Describe how the investment works and what creates or destroys its value.
Pro tip Use plain language to expose gaps hidden by technical vocabulary.
- 2
Mark the unknowns
Identify anything material that you cannot understand or value with confidence.
Pro tip Say “I don't understand” without treating it as a personal failure.
Watch out Sophistication and complexity are not substitutes for comprehensibility.
- 3
Locate the perimeter
Decide whether the opportunity sits inside or outside your actual competence.
Pro tip Judge the boundary honestly rather than stretching it to include an attractive opportunity.
- 4
Abstain outside the circle
Stay away when the opportunity lies beyond the perimeter, regardless of market enthusiasm.
Watch out Do not invest merely because others appear to understand the product.
In the wild
A former student sent Johnson material on then-nascent mortgage-backed securities and asked him to consult. Johnson concluded that he did not understand how anyone could value the products and could not help.
→ He refused to claim competence in a product whose valuation he could not understand.
Johnson cites Buffett staying away from technology investments in the late 1990s because he did not understand them, despite criticism that he was a dinosaur.
→ Staying inside the perimeter avoided exposure to the subsequent crash.
Common mistakes
Being ashamed of uncertainty
Refusing to admit a knowledge gap pushes decisions beyond the investor's real competence.
Measuring the circle by size
The model depends on respecting the perimeter, not proving that your expertise covers many areas.
Is it for you?
Best for
Investors evaluating complex securities, unfamiliar industries, or fashionable opportunities.
Not ideal for
Situations where a qualified specialist has explicit authority and the decision does not depend on the evaluator's own understanding.
From the transcript
“it's the idea of your circle of competence, So not how big your circle of competence is, it's that you stay within its perimeter.”
“Don't be ashamed to say that you don't understand something.”
From the episode
Interview With Robert Johnson: Masters in Business (Audio)