Howard Marks: The Need for 'Second-Level Thinking'

Investors who wish to succeed must do more than just follow the crowd

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Feb 28, 2019
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“I didn’t set out to write a manual for investing. Rather, this book is a statement of my investment philosophy. I consider it my creed, and in the course of my investing career it has served like a religion.”

Howard Marks (Trades, Portfolio) wrote those words in the introduction to his 2013 book, “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.” It is based on his occasional memos to clients at the Trust Company of the West and then at Oaktree Capital, the company he cofounded in 1995.

Rather uniquely, he invited four fellow thinkers to annotate his work for additional depth and perspective. They were Christopher Davis, Joel Greenblatt (Trades, Portfolio), Seth Klarman (Trades, Portfolio) and Paul Johnson of Columbia Business School. All share his commitment to value investing.

The title originated with a client meeting in which Marks explained the most important thing about investment success, only to find himself trotting out a series of most important things—18 of them in total.

He thought of these important things as bricks in a wall, a set of ideas that all require the thoughtful attention of investors. If any one is missing, results could be “less than satisfactory.” He also called the most important things guideposts that keep him on track. In an annotation, he added the book addresses “the human side of investing” and has little to say about financial analysis or investment theory.

The topic in chapter one is what Marks called “second-level thinking.” He offered several examples:

  • Investors who use first-level thinking see what they think is a good company and decide to buy. Those who use second-level thinking see the crowd is enthusiastic about the “good” company and, therefore, believe it is overpriced and proceed to sell.
  • First-level thinkers see low growth and rising inflation, leading them to sell. But second-level thinkers see everyone selling in panic and decide to buy.
  • First-level thinkers believe a company’s earnings will fall, and they sell their shares. Again, second-level thinkers have a different perspective; they think the earnings will fall less than expected, so they buy.

According to Marks, first-level thinking is “simplistic and superficial” and can be done by anyone with an opinion about the future. Second-level thinking is “deep, complex and convoluted” and involves many factors, including:

  • A range of likely future outcomes, rather than just one.
  • Within that range, what is the most likely outcome?
  • What is the probability this will be the actual outcome?
  • The consensus among other investors.
  • The difference between the second-level thinker and the consensus.
  • How does the current price line up with expectations of second-level thinkers and those of the crowd?
  • Determine if the consensus psychology too optimistic or too pessimistic.
  • Where will the price go if the consensus is right? Where will it go if the second-level thinker is right?

In an annotation, Davis noted these are questions investors should always ask themselves about potential investments, but “It’s easy to forget this in the excitement of a new opportunity.”

Marks noted that first-level thinkers seek out “simple formulas and easy answers,” while second-level thinkers know success is never simple. And as we can see from the list, second-level thinkers take on a heavier workload so they can be well informed.

Because of the difference of time and effort required, some “experts” try to make second-level thinking artificially simple, to level the playing field between first-level and second-level thinkers. Mutual funds like investors to think they cannot succeed and should put their capital into their actively managed funds instead.

The author also took a swipe at “proselytizers,” people who try to convert others into believing what they believe. Some, he said, are academics who teach investing, others are practitioners with good intentions who overestimate their competence. And, he wrote, "Finally, there are those who simply fail to understand the complexity of the subject. A guest commentator on my drive-time radio station says, 'If you have had good experience with a product, buy the stock.'”

Underpinning all of this is the fact investing is a zero-sum game, and we have to ask ourselves if we can reasonably expect to be in the top half. That’s unlikely for first-level thinkers because they think the same way as other first-level thinkers, and come to the same conclusions. Marks wrote, “All investors can’t beat the market since, collectively, they are the market.”

To beat the market, to get into that top half, you must be a second-level thinker, outthinking and outworking the consensus, or the crowd. To achieve outstanding performance, you must develop correct, non-consensus forecasts, which is difficult to do and to act on.

Marks added many people had told him the following matrix had an impact on their thinking:


He concluded chapter one with these thoughts:

“Those who consider the investment process simple generally aren’t aware of the need for—or even the existence of—second-level thinking. Thus, many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers. To consistently achieve superior investment returns, you must be one of them.”


Ironically, Marks’ ideas about second-level thinking reflect a consensus among value investors who believe the hard work of identifying intrinsic value, margins of safety, ratios such as return on capital and more will pay off.

Taken a step further, second-level thinking is a necessary but not sufficient element in successful investing because second-level thinking depends on a pre-existing attitude and work ethic.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

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