Warren Buffett and Charlie Munger, the legendary investors behind Berkshire Hathawayhave repeatedly advised investors to stick to their "circle of competence;" in other words, invest in things that you know and understand.

That's a great insight, and most investor's are familiar with the concept. But it's not always easy to determine the perimeter of your own circle of competence. Fortunately, at this year's annual shareholder meeting in Omaha, a plucky, young shareholder from San Francisco asked Warren and Charlie how to determine one's own circle of competence. 

Below are my notes on the shareholder's question, along with responses from Warren and Charlie.

Shareholder: You have said that people should operate within their circle of competence? How should we figure out what our circle of competence is?

Warren Buffett: Good question! Some of the people in the audience identify with it (laughs). Be self-realistic. That applies outside of business, as well. Charlie and I are reasonably good at knowing the perimeter of our circle of competence. I would say in my own case, I've gone out of it more often in retail than any other arena. It's easy to think you understand retail, and then subsequently find you didn't, as in the department store in Baltimore.You can say I was outside my circle when I bought Berkshire, though; I originally bought it to resell. But when I decided to buy control, that was a dumb decision -- but that worked out.

Being realistic when realizing you own shortcomings is important. There are a number of CEOs who don't know where their circle begins and ends! The best really know when they are playing the game that they're going to win. The ultimate was Mrs. B. at Nebraska Furniture Mart. She told me she wanted cash, not stock. It might seem like a bad decision, but it wasn't. She didn't know stocks. She knew cash, property, and retail, so it was a good decision.

When you're playing the game versus playing outside the game, knowing the difference is a huge asset. I can't tell you how to do that yourself. Asking your friends who know you may help. Charlie's helped me, telling me, "What the hell do you know about that?"

Charlie Munger: I don't think it's as difficult to figure out competence as it may appear. If you're 5-foot-2, you don't have much future in the NBA, and if you weigh 350 pounds, you shouldn't dance ballet. If you can't hardly count cards at all, you shouldn't try playing blackjack. But competency is a relative concept. What I need to get ahead is to be better than idiots, and lucky for me, there was a lot of them.

Buffett: You're ruling out everything I want to do!

As an investor, you want to be realistic with yourself, and you should surround yourself with friends or associates who give you honest feedback. But also seek out areas or strategies that allow you to compete with an advantage.

For instance, as an average retail investor, you're unlikely to win against Wall Street professionals on the basis of better information, more sophisticated financial analysis, or trading speed. Thus, you're not likely to make money as a short-term trader.

But as my colleage Morgan Housel has written, there are things that you can do that Wall Street can't that can make long-term investing a successful enterprise.

Brendan Mathews owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.