Second-Level Thinking

Over my three-decade career, I have been blessed to work with many smart people and benefit from the wisdom of some great investors.

Howard Marks, whom I have never met but whose insights have been a key part of my approach to my firms, is one of the great investment minds of our time. He is the co-founder of money-management firm Oaktree Capital Management.

Howard and I have never met, but his approach was deeply ingrained in the process of my last big hedge fund. In fact, Howard's son Andrew worked with us, and I am proud to say I helped him develop his analytical skills.

Howard is known for his comprehensive investment letters and memos, which he publishes for Oaktree.

He has a tremendous reputation. Read this quote from Warren Buffett, “When I see memos from Howard Marks in my mail, they're the first thing I open and read. I always learn something, and that goes double for his book."

The most powerful of Howard’s insights that we used was his concept of “Second-Level Thinking.”

Howard’s concept was that most investors operate with “First-Level Thinking.” This is where they buy a stock because the company is growing earnings or they are going to beat numbers.

The problem is that if THIS investor knows this information, then many other investors will likely KNOW it. The insight has no informational edge.

The challenge is that when the company reports the (expected) good news, the stock often does NOT perform as the investor hopes.

The key is to develop insights that are “Second-Level Thinking.”

Here is an excellent explanation of what he is talking about from a 2015 essay he published…

"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 others – both more powerful and at a higher level. Since others 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…

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.”

We encourage you to read the entire essay here.

There is a LOT of wisdom packed in there!

We want to simplify it and tell you how we executed this insight in our firm.

The key was constantly challenging ourselves – are we simply thinking what everyone else is thinking?

This required a level of critical examination and reviewing as much of the data available as possible.

One of the great aspects of the modern investing world is we have access to an incredible amount of information. Every investor can access public sources like X/Twitter or StockTwits.

Spend a little money, and you can get access to other sources like Seeking Alpha. There is a ton of information to help you determine whether your thinking is consensus.

Our advice is that the more confident you are about a particular idea, the more you should challenge yourself about whether you are engaged in first-level thinking.

Our personal experience is that when we had the strongest conviction, it was often when the market also agreed with us the most. That is a dangerous place to be when investing.

Not only are you unlikely to produce better-than-average returns, but you are often setting yourself up for failure and volatility.

Again, we encourage you to read Howard's full essay above and familiarize yourself with his investment wisdom.