The Three-Circle Test: Why You Don’t Need to Be the CEO to Pick Winning Stocks

The recent episode of The Investing for Beginners Podcast featuring Stephen Morris’ “three-circle test” has sparked a much-needed conversation about the dangers of investing beyond one’s knowledge depth. While the test itself is not new, its application to everyday investors is a timely reminder that even seasoned traders can fall prey to overconfidence and poor decision-making.

At its core, the three-circle framework is simple: an investor must be able to answer five basic questions about a company before buying into it. Can they explain the business in plain English? Who pays them, and how do their finances work? What sets them apart from competitors (their “moat”), and what could potentially destroy their business overnight? If the answers are unclear or lacking, then the investment is outside one’s circle of competence – a concept popularized by Warren Buffett.

However, there’s an often-overlooked aspect to this framework: position size. As co-host Andrew Sather notes, the amount of money invested in a particular stock directly influences how much knowledge one needs to possess about it. A small position can tolerate a certain level of ignorance, but as the stakes rise – and with them, the potential losses – so too does the required level of understanding.

The Danger Zone: Where Knowledge Fails

Morris’ three-circle test is designed to keep investors out of the danger zone, where they risk losing significant amounts of money due to a lack of understanding. This zone is characterized by anything beyond the second ring, which covers industry economics and product knowledge. While it’s tempting to delve into complex financials or market trends without proper foundation, doing so can be catastrophic.

The problem lies in confusing brand recognition with business acumen. Just because a company has a well-known name or product doesn’t mean one understands its inner workings or financial health. This is where the framework truly shines – by separating the wheat from the chaff.

The Stakes Are Real

The consequences of investing beyond one’s knowledge depth are all too real. When market trends shift, an investor without a solid understanding of the company’s mechanics and financials is left struggling to make informed decisions. They’re forced to base their choices on incomplete information or speculation.

Permanent capital loss is not just a theoretical concept; it’s a very real possibility when investors overextend themselves financially and cognitively. Buying into someone else’s story without doing one’s own due diligence is akin to paying retail for a product – often with disastrous results.

The Real Challenge: Putting Theory into Practice

While the three-circle test provides a useful framework, the real challenge lies in putting it into practice. As investors navigate their portfolios, they must constantly assess their level of understanding against the size of their position. This is an ongoing process that requires humility and a willingness to admit when one doesn’t know something.

In an era where financial literacy is often touted as key to success, it’s refreshing to see a framework like Morris’ three-circle test that emphasizes knowledge over hype or brand recognition. As investors, we would do well to remember that our portfolios are only as strong as our understanding – and that true wisdom lies in crafting one’s own story rather than buying into someone else’s.

The game is not just about picking winners; it’s also about knowing when to hold back. By embracing the three-circle test and its emphasis on position size, investors can avoid overconfidence and stay focused on what truly matters: understanding their investments.