Howard Marks - Why you need to develop “second-level thinking”

Key takeaways at the end

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What is second-level thinking?

• 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."

• First-level thinking says, "The outlook calls for low growth and rising inflation. Let's dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy!" […]

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. […] 

First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can't be the route to superior results. 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 non-consensus forecasts are hard to make, hard to make correctly and hard to act on. […] 

The upshot is simple: to achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. That's not easy. […]

For your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus. Different and better: that's a pretty good description of second-level thinking.

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. [...]

Chapter 1, The Most Important Thing (2018)

* Bold emphasis added

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Key concepts and takeaways:

• Form your own differentiated view: “Consensus view” typically means the average forecast / projections of the analysts covering a particular stock, or more broadly, the view of the “market”, which is reflected in the current share price. Second-level thinking is not about beating these analysts or the market on the next quarterly results. It is about building your own long-term view on the business. To do that, it is helpful to develop your circle of competence and know its boundaries, as described in other posts. In building this differentiated view, it might be helpful to ask questions such as: “What is the market likely assuming?”, “How is my view on the long-term prospects different?”, “What is the market likely missing?”. Unless you have formed your own view, it will be difficult to act confidently when market fluctuations occur.