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The Magical Powers of Second-Level Thinking!

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The levels of thinking are complex and not considered to be highly critical. However, to be successful, a person needs to move beyond what is referred to as first level thinking.

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The first level of thinking is quite simple and straightforward. It involves looking at the problems in one, and only one, way. Th thought process remains superficial and follows the herd mentality. It goes in the traditional direction all the time, and follows the expected sequence of events.

On the other hand, second-order thinking or second level thinking is extraordinary. The second level thinkers think differently, perform differently and hence, get different and unexpected results. Of course, the unexpected results can be less than average as well, however, there can be no gain without taking risks, isn’t it?

The basis of second level thinking is that extraordinary results can only be achieved through extra ordinations actions. If the thinking remains confined to a norm, there is no way that the results will diverge from the normal. Instead, it is only when the thoughts diverge that the results can diverse and become different from the ordinary.

In his extraordinary book “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”, Howard Marks has beautifully explained second-level thinking. He writes,

“Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Th us, your thinking has to be better than that of others— both more powerful and at a higher level. Since other investors may be smart, well- informed and highly computerised, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different.

What is second- level thinking?

  • First- level thinking says, “It’s a good company; let’s buy the stock.” Second- level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
  • First- level thinking says, “Th e outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second- level thinking says, “Th e outlook stinks, but everyone else is selling in panic. Buy!”

First- level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). Second- level thinking is deep, complex and convoluted. Th e second level thinker takes a great many things into account.

This is when second-level thinking is applied to the field of investing. In my opinion, investments thrive on second-level thinking. If all the investors had only the first level of thinking, there would have been no bulls or bears. Everyone would follow the same path, and there would have been all buyers or all sellers for a particular stock at a particular time. It is the second level of thinking that sets the investors apart. The first-level thinkers follow the trend, while the second-level thinkers flow against it.

The difference in workload between first- level and second- level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former. First- level thinkers look for simple formulas and easy answers. Second level thinkers know that success in investing is the antithesis of simple. Th at’s not to say you won’t run into plenty of people who try their darnedest to make it sound simple. Some of them I might characterize as “mercenaries.” Brokerage fi rms want you to think everyone’s capable of investing— at $10 per trade. Mutual fund companies don’t want you to think you can do it; they want you to think they can do it. In that case, you’ll put your money into actively managed funds and pay the associated high fees.

Of course, it is much easier to be a first-level thinker. It does not involve too much work, and too much divergence from the rut. However, it does not take one too far as well. If an investor plans to take the high road, second-level thinking is the way to it.

For your performance to diverge from the norm, your expectations— and thus your portfolio— have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second- level thinking.”

Very rightly said! Second-level thinking is indeed different and undoubtedly better. In the field of investment, one does not need to know everything, he just needs to know what others don’t. The viewpoint and perception needs to be modified in a way that a tangential approach becomes your way of work. Moving round and round in the same circle will not bring much outcome, as compared to cutting a tangent and thinking second-level!

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