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Stepan Lavrouk
Articles (172) 

Howard Marks: The Importance of Second-Level Thinking

To beat the market, you must be unconventional, but you must also be right

May 17, 2019 | About:

It is very difficult to have an original thought. Some would even say it is impossible. Although this outlook seems a little pessimistic, it certainly has some merit to it. Thinking outside the box is tough. Unfortunately, unconventional thinking is also a prerequisite for unconventional performance. In his book, "The Most Important Thing," investor Howard Marks (Trades, Portfolio) called this "second-level thinking" -- the extra legwork that investors who wish to beat the market need to do.

Who cares anyway?

Well, not everyone. Some people are perfectly content to have their savings compound at whatever the market rate is, and that is perfectly fine. You can buy an index, and so long as the economy keeps growing and we do not enter a prolonged slump of any kind, your wealth will grow at the average rate of return. But many people are not satisfied with that. Many people choose to take a much more active role in managing their savings, in an attempt to beat the market. But, everyone else in the market is trying to do the same thing. Marks put it best in his book:

“Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Thus, 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 computerized, 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.”

So what is second-level thinking?

Marks distinguishes second-level thinking from first-leveling thinking. First-level thinking is the surface analysis you do when you think about anything, the first thought that pops into your head. All it requires is having an opinion about something. And while there is nothing wrong with that in day-to-day life, it becomes a problem in the zero-sum arena that is the market. If you are having a thought, chances are that everyone else has had that thought. So you need to think about how everyone else will act, given that they know this, or in Marks’ words:

“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.'”

Simply taking the opposite view to the consensus is not enough, however. On top of being unconventional, you also need to be correct, which is much harder to do. In fact, being unconventional and being wrong is a deadly combination that should be avoided at all costs. But if it were simple, everyone would do it.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

Rating: 5.0/5 (1 vote)

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Comments

asawhneyy
Asawhneyy - 3 weeks ago    Report SPAM

Icon is always bearish for the last 10 years-yet he wants to be activisit

Marks always not bearish nor bullish

Buffet/munger clever statements -we don't invest in technology -because we don't understand , then some fellow bought Amazon--clever?

Do I trust them?

Stepan Lavrouk
Stepan Lavrouk - 3 weeks ago    Report SPAM

To be fair, you can't expect them to tell the world what their edge is, beyond perhaps a general explanation of the principles they operate on.

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