Why “Second-Level Thinking” Is Critical For Outperformance

by | Aug 30, 2022

“It’s not supposed to be easy. Anyone who finds it easy is stupid”.

Charlie Munger

In his book “The Most Important Thing” Howard Marks dedicates the first chapter to “Second-Level Thinking”. Marks says “to consistently achieve superior investment returns you must be one of them (a second-level thinker)”.

What is second-level thinking and why is it important?

What is Second-Level thinking?

Second-level thinking is the ability to look beyond the initial opinion of the market. Let’s say the market expects a company to post earnings growth of 10%, but it only grows by 7%. The market reacts negatively to this underperformance and sells the stock. The second-level thinker looks deeper and realises that the company had a one-off expense that is unlikely to occur again. The second-level thinker realises that this is just a temporary drop in earnings growth and buys the stock.

“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 stocks are overrated and overpriced; let’s sell’”. 

“First-level thinking is simplistic and superficial, and just about everyone can do it”. 

“Second-level thinking is deep, complex and convoluted”.

Why it’s important?

Second-level thinking is critical if your goal is to outperform the market.

“Anyone can achieve average investment performance – just invest in an index fund that buys a little of everything”. But if you want to earn above-average returns “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 insights they dont possess”. 

Second-level thinkers have the ability to be contrarian, to go against the herd. The only way to beat the market is to think differently from the market because “All investors can’t beat the market since, collectively, they are the market”.

“The problem is that extraordinary performance comes only from correct non-consensus forecasts, but nonconsensus forecasts are hard to mark correctly and hard to act on”.

“You can’t do the same thing as others do and expect to outperform”.

“If your behaviour is conventional you’re likely to get conventional results – either good or bad. Only if your behaviour is unconventional is your performance likely to be unconventional, and only if your judgements are superior is your performance likely to be above average”. 

Summary

  • Second-level thinking is the ability to look beyond the obvious.
  • Second-level thinkers are able to think differently from the market.
  • If you think the same as the market you will get the same results as the market.
  • Thinking differently from the market is not enough, you also have to be right.
  • Being contrarian is difficult, the market is often right, that is why it is difficult to beat the market.

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