Circles 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. – Berkshire Hathaway 1996 annual letter

The Circle of Competence is an often-cited mental model attributed to Warren Buffett, per the quote above. It isn’t a novel idea, but his application toward investing is a window into his legendary discipline. Discipline in investing is all about putting oneself in a position to succeed. Its a bedrock principle in achieving excellence, but it is too often overruled. Discipline is essential given the psychological wiring of humans and our difficulty making high quality decisions in periods of stress or elation. That degradation of decision-making results in slippage of performance, which compounds through time. At Epsilon, we take this to heart not as a poster we put in the supply cabinet, but as a pillar to our investment process. We humbly offer a contribution to Buffet’s lesson through a slight modification.

Circle of Alpha Generative Competence

We call this tweak the Circle of Alpha Generative Competence. You see, money managers tend to be pretty competent people. They have had to gain the trust of institutions to operate, and these institutions are pretty capable at determining competence. The very fact that managers attain institutional capital is almost a self-reinforcing admission of competence. Hey I have to be competent if I raised X Million dollars! The ego is perhaps the central force at play at most hedge funds, especially compared to other industries. It’s often what institutions look for. But competence and alpha generation are two different things, and ego wreaks havoc on this distinction.

Trading Competence

To give a personal example, at Epsilon we are competent at trading. We have done so professionally for years, have read about market structure, have accumulated significant amounts of data trading millions of shares, have A/B tested algorithmic efficacy, et al. In short, we strive to stay abreast of changes to market structure and its impact on our ability to take risk in an intelligent way. But trading is not a means of alpha generation for us. We do not have alpha-generative competence in trading. Put toe-to-toe with high frequency trading firms and experienced prop traders, our clients’ capital would not be well positioned to prosper. 

This is a connundrum. The money manager has to trade in order to express her ideas, so she might as well try to gain edge in that trading. Not doing so feels like an abdication of responsibility, or at the very least, an admission of inadequacy. Going back to the self-reinforcing myth of competence with money managers, it is easy to conflate competence with alpha-generative competence. Buy one dip, sell a top, and you’re feeling good about your trading acumen. As we have communicated to our clients, the market’s speculative nature seduces even the most orderly practitioner, often at their unbeknownst loss. Like Odysseus sailing between Scylla and Charybdis, at Epsilon, we relinquish ego and constrict ourselves by rule. 

Odysseus Avoiding the Siren’s Call (Wikicommons)

Adherence of Discipline

Without rules, it’s easy to be lulled into complacency. Complacency leads to cracks. Cracks in discipline are nefarious, like tricky bugs in messy code. They are often overlooked. On the topic, we often quote Howard Marks, our favorite philosopher on risk. He says “refusing to be part of the emotional swings” is crucial to successful risk management. “Those of us who are able to resist, it’s not because we don’t feel those influences. It’s because we resist. You have to resist if you are going to outperform.” His view is to be aware but to resist the siren’s call. Our view is not to fight it; to be intoxicated by her sweet melody. But to restrain oneself from acting on it.

Our rules constrict us from trading outside of pre-defined periods. Those periods coincide with when we derive algorithmic factor scores for securities. These scores and these scores alone are used by us to express risk. By binding our expression of risk to a rule, we restrict the act of trading from the speculative pursuit. We bind ourselves to our Circle of Alpha Generative Competence.

The freedom to express investment ideas leads one to conflate talents: the talent behind underwriting a security selection decision and that with trading it speculatively. In our estimation, the two fool money managers into believing they are intertwined. After all, if one’s research leads to say a price target for a security, why shouldn’t one trade around the oscillations of a stock price?

For one, they engender behavioral bias, as humans are wired to anchor to their prior rather than to update them. Updating priors solely on price movement is a perilous task, as differentiating noise from reality while maintaining a disciplined view is extremely challenging. One second guesses if a stock moving against them is due to information they didn’t capture. The cortisone levels rise, and behavioral biases begin to churn. These two skills are most often mutually exclusive and value destructive when combined. While some may be experts in tactical trading, we know our alpha-generative competence does not fall in this camp. Thus, we restrict the intoxicating allure of undisciplined trading.

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The information contained in this article was obtained from various sources that Epsilon Asset Management, LLC (“Epsilon”) believes to be reliable, but Epsilon does not guarantee its accuracy or completeness. The information and opinions contained on this site are subject to change without notice.

Neither the information nor any opinion contained on this site constitutes an offer, or a solicitation of an offer, to buy or sell any securities or other financial instruments, including any securities mentioned in any report available on this site.

The information contained on this site has been prepared and circulated for general information only and is not intended to and does not provide a recommendation with respect to any security. The information on this site does not take into account the financial position or particular needs or investment objectives of any individual or entity. Investors must make their own determinations of the appropriateness of an investment strategy and an investment in any particular securities based upon the legal, tax and accounting considerations applicable to such investors and their own investment objectives. Investors are cautioned that statements regarding future prospects may not be realized and that past performance is not necessarily indicative of future performance.