Why Second-Level Thinking Is Vital for Investors

Advice from Howard Marks for the current market

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Jul 10, 2020
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In his September 2015 memo to investors of Oaktree Capital Management,

Howard Marks (Trades, Portfolio) proclaimed that it is not easy for investors to beat the market. Marks tried to make it clear in the memo that if you think it is easy to achieve unusual profits in the stock market consistently, you overlook the way stock markets operate.

Even though it is five years old, this advice remains highly relevant today. Marks has several decades operating in the stock market. During this time, he has seen multiple market booms and busts.

To consistently earn positive returns from the stock market, it is essential to understand what does not make a good investor as what does.

What does this mean? It means that we have to acknowledge that we will make mistakes and that the market is not there to reward everyone who invests. It is a marketplace for people to exchange shares. It has no emotion and no desire to reward or penalize anyone.

Every investor who operates in the market is trying to make the most of their situation based on the information they have. Some investors may have more information, some may have less. Investors who have less information may sometimes be more successful than those with more information.

There's no rhyme or reason to the stock market. Prices are determined by thousands of transactions every day, and the price may or may not reflect the fundamental value of each business. Understanding these principles is just as important as any other part of investing.

Marks on second-level thinking

Marks said the following in his 2015 memo:

"Everyone wants to make money, and especially to find the sure thing or "silver bullet" that will allow them to do it without commensurate risk. Thus they work hard, searching for bargain securities and approaches that will give them an edge. They buy up the bargains and apply the approaches. The result is that the efforts of these market participants tend to drive out opportunities for easy money. Securities become more fairly priced, and free lunches become harder to find. It makes no sense to think it would be otherwise...

People who think it can be easy overlook substantial nuance and complexity."

Investors need to understand this principle. The stock market is a vastly complex machine that does not follow any rules. As we've seen recently, that means even companies in the process of Chapter 11 bankruptcy can become successful stocks to hold for a limited period. The market has also been placing sector-leading valuations on companies that are yet to make a profit.

To avoid being swept up in the madness and euphoria, we need to take a step back and take a breath. That's where Marks' principle of second-level thinking comes into play. As he described in the memo:

"First-level thinkers see what's on the surface, react to it simplistically, and buy or sell on the basis of their reactions...the first-level thinker simply looks for the highest quality company, the best product, the fastest earnings growth or the lowest P/E ratio...

The second-level thinker goes through a much more complex process when thinking about buying an asset. Is it good? Do others think it's as good as I think it is? Is it really as good as I think it is? Is it as good as others think it is? Is it as good as others think others think it is? How will it change? How do others think it will change? How is it priced given: its current condition; how I think its condition will change; how others think it will change; and how others think others think it will change? And that's just the beginning. No, this isn't easy."

Disclosure: The author owns no share mentioned.

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