Circle of competence

James Carville, a one-time strategist for Bill Clinton, said “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

The financial markets are an interesting cultural phenomenon. Few people understand what they are and it is easy to resent them.

The markets have an attraction of their own, similar to professional sports. There are players, statistics and activity. There are participants, observers and commentators. There are facilitators, advisors and con-artists.

Out of all this activity – of people doing their own thing – emerges a river of transactions, deals between people trading commodities, stocks, currencies, bonds, derivatives and increasingly complex products.

All this activity is supposed to make things better, to make us all better off.

Benjamin Graham, the father of value investing, used to say that in the short run a market is like a voting machine, telling you which companies are popular and which ones unpopular on a daily basis.

In the long run, however, the market is a weighing machine, telling you whether a company is good or bad.

Some people say that the market price has all the information you need to know in it, so there is no need to know anything else. In other words, markets are efficient.

Others such as Warren Buffet say that while markets are frequently efficient, it does not follow that they are always efficient. They can sometimes act in a manic-depressive way, pushing down the value of perfectly good companies and sending the values of bad ones sky high.

So how do you make a good decision when faced with markets?

Your options depend on how much you know about the subject you are making a decision about. What is your circle of competence?

If you are inside that circle, then you can take certain risks. If you are outside, perhaps you should protect yourself.

They key to better decision making in financial markets is knowing yourself, knowing the limits of what you know and making decisions about things that lie inside your circle of competence.

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