How Do You Utilize 2nd Level Thinking?

“If you don’t have superior insight, how can something be to your advantage?” – Howard Marks

Last week I had the chance to speak to a group of finance students at Drexel University about my experiences in the investment industry. I tried to share with these students some of the things I wish I had been taught when I was in school.

One of the subjects I touched on was second level thinking. This is an important concept on market expectations developed by Oaktree’s Howard Marks. Marks explained this theory in detail in his book, The Most Important Thing. Here’s one of his examples:

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.”

Following the talk, one of the students asked how to develop a second level thought process. I thought this was a great question, because a simple example doesn’t always tell the whole story. This isn’t just something you can pick up from a book and master right away, if ever. Having a deep understanding of what is likely priced in and consistently making smart decisions based on that analysis is what puts Marks in the top 1% of investors. It’s not easy.

But even if you’re unable to develop the same kind of second level mind that Marks has crafted over the years, you can still use this thought process to make yourself a better investor. Here are a few things I shared with this student on how to generally utilize second level thinking:

  • Always be willing to see both sides of every argument or investment stance you take. You have to be willing to actively seek out opinions that are different than your own. No one is right all the time and thinking about where you could be wrong shows intellectually honesty and the self-awareness to know you’re not infallible.
  • Think in terms of probabilities, never certainties.
  • Don’t judge your decisions based on the outcomes; judge them by the process you took to make them.
  • Remember to think in terms of relatives, not absolutes. Markets are all about expectations, especially over the short to intermediate term. It’s not always about things getting better or worse, but less good or less bad. A misunderstanding of this concept has cost plenty of investors a lot of money over the past 5 or 6 years.
  • Be humble or the market will do it for you.
  • Always consider the difference between price and value. Any security or asset class can make for a good investment at one price and a poor one at another.
  • Never become too confident in your own abilities.

Very few investors are able to do what Howard Marks does. Everyone has to be willing to ask themselves:

  • Do I have insight into this investment that someone else doesn’t?
  • What is my edge here?
  • What do I know that the market doesn’t?

I concluded my talk with this student by telling her that you don’t have to have an opinion on everything that’s going on in the markets, nor do you need to act on every impulse you get from the market’s movements or your own research. I told her that I always start with the assumption that less is more. No one has all the answers and you’ll never be able to outsmart the markets at all times.

Source:
The Most Important Thing

Further Reading:
One of the Worst Arguments in Finance
A Lesson in Market Crashes

Here’s what I’ve been reading this week:

  • Being well-read is one of the best ways to get ahead (Investor’s Field Guide)
  • It’s not easy being a value investor (Servo)
  • The 10 Harsh Financial Commandments (Irrelevant Investor)
  • The battle between your present and future self (Boomer & Echo)
  • Eddy Elfenbein: “For some reason, it’s considered much more sophisticated to warn that stocks are in a terrible bubble. No one gets credit for telling people that there’s not much to worry about.” (Crossing Wall Street)
  • The number one thing that makes you susceptible to fraud (Reformed Broker)
  • The priceless art of not caring (Motley Fool)
  • Nothing works all the time (Alpha Architect)
  • On embracing stupid (Notes from the Hedge)
  • 13 life lessons from Matthew McConaughey (Medium)
  • Podcast: A great case study on how to run a business and treat your employees and customers the right way from Vanguard CEO Bill McNabb (Big Picture)

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Discussions found on the web
  1. innerscorecard commented on May 21

    I think the best way to develop second-level thinking is to engage in pursuits where such thinking is rewarded on a quick time-frame. This will develop a link in one’s mind between correct second-level (or higher) thinking and the reward for such insights.

    The problem with the markets is that the rewards are on inconsistent and long scales of time.

    Games with pari-mutuel systems compress the process by which these inputs turn into outputs. Poker is traditionally the best one for this, but Magic: the Gathering or any other modern competitive games will work as well.

    • Ben commented on May 22

      Maybe. But I think the takeaway has more to do with slowing down and making sure you’re not make quick-hit decisions. Those are normally the times people get in trouble by using their intuition without thinking things through. But I think what you’re trying to say is you can develop thoughtful decisions to come to you quicker by doing it over and over again?

      • innerscorecard commented on May 22

        Yup, that’s basically it. I wonder if it works. I’m sure it’s possible to test empirically.

  2. Robb Engen commented on May 22

    This sounds similar to the idea of system 1 and system 2 in Thinking, Fast and Slow. Acting on our gut reaction or intuition is probably not a good thing and we should slow down, think about our biases, take in all relevant information, and that will lead to better decisions.

    Thanks for the mention!

    • Ben commented on May 22

      Good point. I never put that one together but you’re right that the first level is the intuitive while second level is the more thoughtful. Such a simple concept, yet so important to understand.

      • John Richards commented on May 22

        Recent studies indicate that the rational mind, while it can assess pros and cons about any decision, essentially can’t make a decision – no matter how lopsided the evidence is on one side. Analysis paralysis if you will, taken to extremes. Decision making is apparently an emotional process involving the value we place on the result of the transaction [I want/need a new car!], and on the object of the transaction [how we perceive it intrinsically (nice car!) or in relation to ourselves (I’d look good driving that car!)]. It’s easy for the initial, impulsive emotional state to overwhelm the slower process of rational consideration. I like to do a lot of research before making a big purchase, so that I narrow my field to acceptable options. From there I go with what feels right. Inverting the process – identifying rational considerations and ranking my options up front – eliminates most of the fear of a poor decision, and frees me to indulge my emotional/intuitive responses, as well as respond with flexibility to new information (I really like that car and it’s offered with 0% financing! If they meet my target price, it’s a go!). It also helps fend off buyer’s remorse, even if the purchase doesn’t work out as well as I’d hoped. [This topic makes me wonder about parallels to value investing, but I’ve always been an Index fund investor.]

        • Ben commented on May 22

          I think the paralysis by analysis is even worse these days with all of the investment options and products people have to choose from. The first step is actually realizing that we’re all irrational. Even those that understand cognitive biases think these biases don’t affect them personally. I’m a big fan of negative knowledge and inverting as well.

    • Ben commented on May 22

      Good call. Funny how many people don’t start with that mindset.

  3. Manoj Pawa commented on May 22

    Third Level Thinking: since second level thinkers are selling, lets buy.

    • Ben commented on May 23

      Reverse-reverse psychology?