This is guest blog post from Tom Beevers, ex-Portfolio Manager at Newton and now CEO and Co-Founder of StockViews.
I am a big fan of the memos from Howard Marks. They are in my opinion required readings for any investor. They come from someone with close to fifty years of experience in all types of markets and fads.
“Second-Level Thinking” is a term popularized by Howard Marks of Oaktree Capital to describe those investors who look beyond the obvious.
According to his view of the world, most investors are “First-level thinkers” who react primarily based on what they see in front of them.
As an investor it’s been a hugely valuable concept to me and, as you’ll see, it complements nicely the work done by other great investors like Warren Buffett and Seth Klarman.
If you’re interested to read more I can highly recommend reading his book “The Most Important Thing”
FIRST LEVEL THINKERS
First-level thinkers react to what they see in front of them.
If a company is releasing a cool product, they buy the stock. If a company is growing sales rapidly through overseas expansion, they buy the stock. If a company has been hit by a profits warning, they sell the stock.
That’s not to say these are necessarily the wrong decisions, it’s just that on average you’re unlikely to outperform the market with this simplistic approach.
If you’re planning a career in asset management or equity research, you’ll meet a lot of these people. Don’t be too upset by their presence – after all these are the participants who create the opportunities for the second-level thinkers.
If you don’t recognize them, there’s a risk that you’re engaging in this behavior yourself – in that case, read on, read Marks’ book and train yourself to become a “second-level thinker”!
SECOND LEVEL THINKERS
Second-level thinkers are always thinking beyond the obvious.
They recognize that what is obvious to everyone is already factored into the share price. They know that their advantage lies in reaching a more accurate answer than the market, and they know this isn’t always easy.
They have a robust approach for determining the value of a stock independent of the market, and at the same time they have a deep understanding of the psychology that drives Mr. Market.
These two attributes make for powerful bedfellows and enable the smart investor to assess great opportunities. The second-level thinker is constantly asking themselves two questions:
- How is my view different to the market?
- Is my view more accurate than the market, and if so, why?
The thought process for these thinkers is likely to run something like this, and you should aspire to adopt something similar:
First-level thinkers often fail to understand the process going on with second-level thinkers.
They look at the second-level thinkers and believe they have somehow missed the obvious or are just being dense.
They will ask you questions like “Why are you still holding this stock after the legal issues were exposed?” or “This is the best quality stock in the oil sector – why don’t you hold it in your portfolio?”.
You can explain it to them, but many first-level thinkers still won’t get it.
That’s okay – just don’t get pulled into their way of thinking!
“If your behavior is conventional, you’re likely to get conventional results – either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgements are superior is your performance likely to be above average” – Howard Marks, The Most Important Thing