Top investors possess second-level thinking.

Source: Qile Club

Second-Level Thinking

Columbia Business School Publishing once approached me about publishing a book. When I told them I was ready, they asked me to provide a sample chapter.

By chance, I was able to sit down and type out a chapter emphasizing the importance of 'second-level thinking' without even conceptualizing the theme of the book. This is a crucial lesson that anyone aspiring to be a successful investor must learn. However, I have never explicitly articulated this to my memo readers. Now is the time for me to address this omission.

In the first chapter of the book, I introduced 'second-level thinking' as follows:

Remember, your investment goal is not to achieve average returns; you want to surpass the average. Therefore, your thinking must be superior to others—more thorough and at a higher level.

Other investors may all be intelligent, well-informed, and skilled at using computers, so you must find a distinctive edge. You must think what others haven't thought, see what others haven't seen, or possess insights that others lack. Your reactions and actions must be different from the norm.

— Howard Marks, 'The Most Important Thing'

In short, being correct might be a necessary condition for investment success, but it is not sufficient. You must be more correct than others. The implication is that your way of thinking must be extraordinary. Your behavior, your expectations, and even your investment portfolio must deviate from the norm, and your views must be more accurate than the general consensus.

Being different and better: this is a fairly accurate description of second-level thinking.

When reflecting on Charlie's perspective, the concept of 'second-level thinking' immediately came to mind. Under this excellent overarching title, many important factors that make outstanding investment a challenge can be discussed. In summary, to use Charlie’s words, those who think investing is easy must be first-level thinkers. Allow me to illustrate the difference between the two levels of thinking with a few simple examples from the book.

• First-level thinking

A first-level thinker would say: 'This is a good company, we should buy their stock.' A second-level thinker would say: 'This is a good company, but everyone thinks so, hence it's not the optimal choice. The stock is overvalued and overpriced; we should sell.'

A first-level thinker would say: 'The company will face an unfavorable outlook with sluggish growth. Let’s sell the stock.' A second-level thinker would say: 'The outlook is bleak, but everyone is panicking and selling. This is the time to buy!'

A first-level thinker would say: 'I think this company’s profits will decline. Sell.' A second-level thinker would say: 'I think the company’s profit decline is much less than what people expect. Unexpected positive news can boost the stock price. It’s a buy.'

First-level thinking is simple and superficial, something almost anyone can do (which is not a good sign if you want to gain a competitive edge). All a first-level thinker needs is an opinion about the future, such as 'the company’s prospects are bright, which means the stock will rise.'

• Second-level thinking

Second-level thinking is deeper, more complex, and convoluted. A second-level thinker must consider many factors:

What range of outcomes could occur in the future?

What outcome do I believe will occur?

What is the probability that my prediction will be correct?

What is the market consensus?

How much does my expectation differ from the market consensus?

To what extent does the current price of the asset align with the market’s general view of its future price and my own perspective?

Does the consensus reflected in the price indicate excessive optimism or excessive pessimism?

If the public's view is correct, how will the asset price change? If I am correct, how will the price behave?

The key point is that first-level thinkers focus on surface appearances, react simply to superficial phenomena, and buy or sell stocks based on their reactions. They fail to understand that they are operating within an investment market where asset prices reflect and depend on the expectations of market participants. They overlook the fact that others' actions can influence price movements. Moreover, they do not comprehend the implications this has for their likelihood of success.

For example, I live in Los Angeles, and a stockbroker frequently appears on radio programs I listen to while driving. His advice is straightforward:

"If you like a company's product, buy the company's stock." This represents first-level thinking. It is simple and appealing but prone to errors because it ignores the possibility that companies with good products may perform poorly, that good products may become obsolete, or that the company’s stock price may be too high to constitute a sound investment.

In other words, second-level thinkers (and third-level thinkers) carefully deliberate on every angle of each situation.

John Maynard Keynes’ hypothetical newspaper beauty contest, proposed in 1936, serves as an excellent illustration.

Assume that 100 photographs of women are published in a newspaper, and readers are asked to select the six most beautiful ones. The readers with the highest success rate can win prizes.

To win, simple-minded contestants would choose the most beautiful woman. However, note that the competition winner is not selecting the most beautiful, but rather the most popular and most frequently chosen woman.

Thus, the key to winning is not beauty selection but predicting the voting results based on what the average contestant believes to be the prettiest. Clearly, to make accurate predictions, winners must think at the second level. (First-level thinkers would not recognize the difference.)

This is not about using personal judgment to select the most beautiful [face], nor is it about picking the face the public deems most beautiful on average. We have entered the third level, using intelligence to predict what contestants believe the average opinion will be. Moreover, I believe some contestants even engage in fourth-level, fifth-level, or higher-order thinking.

— John Maynard Keynes, 'The General Theory of Employment, Interest, and Money'

Keynes devised this competition to illustrate his perspective on the stock market. In the short term, outperforming the market requires the ability to predict which stocks will gain investor favor. High-level thinkers who understand this dynamic gain an edge in achieving maximum returns.

When Benjamin Graham said the market is a 'voting machine' in the short term, though he explained that it becomes a 'weighing machine' in the long term, he was employing the same line of reasoning.

First-level thinkers focus solely on the highest-quality companies, the best products, the fastest earnings growth, or the lowest price-to-earnings multiples. They are unaware of the importance of second-level thinking or the need for it.

Second-level thinkers go through a more complex process when considering the purchase of an asset.

Is this asset good? Do others view it as optimistically as I do? Is it really as good as I think? Do others share the same opinion? What do others think others believe? How will it change?

What do others think about how it will change? Based on the current situation, I believe its condition will change in a certain way; others think it will change in a certain way; and considering factors such as how others perceive others to think it will change, how is it priced?

These are just the beginning. Yes, it’s not that simple.

Things that everyone追捧 (pursues enthusiastically).

The most prominent characteristic of first-level thinkers and the investment masses is — they like things with obvious appeal.

In my April 2007 book 'Everyone Knows,' I wrote: The broad consensus reached explicitly by investors is almost always wrong. First, most people do not understand the process required for an asset with extraordinary potential to become profitable before achieving returns. Second, the general views formed by the public regarding an investment may undermine its profit potential.

For example, investments that 'everyone' believes are good obviously won’t be that straightforward in my view.

If everyone likes it, it is likely because this asset has performed well in the past. It seems that most people believe that if it has performed exceptionally so far, it also implies that future performance will remain strong. However, it is more likely that the outstanding performance thus far represents an advance realization of future performance, hence indicating below-average performance going forward.

If everyone likes it, it may mean that investment enthusiasm has driven up prices, making further appreciation relatively unlikely. (Of course, there exists the possibility of moving from 'overvalued' to 'further overvaluation,' but I wouldn’t count on that happening.)

If everyone likes it, it may indicate that value in this area has been excessively exploited, and excessive capital inflows have left no undervalued assets.

If everyone likes it, there is a significant risk of price declines when the collective sentiment shifts and the crowd seeks to exit the investment. Good investors will know when the price of an asset falls below its intrinsic value and will buy those assets at that time. Prices are only likely to fall below their true value when most people fail to foresee the value of an investment.

Yogi Berra is well-known for his famous saying, "No one goes there anymore; it's too crowded." This is as absurd as saying, "Everyone realizes this investment is a bargain." If everyone realized that, they would buy in, in which case the price wouldn't remain low.

Thus, assets with the most apparent advantages become the object of everyone’s pursuit. They may also be the most sought-after and overpriced, thereby becoming the riskiest and least reliable.

About a decade ago, everyone in the U.S. was enthusiastic about investing in real estate, particularly residential properties. This trend was driven by some seemingly convincing "widely accepted truths," such as "you can always live here," "housing prices will keep rising," and "real estate is an inflation-proof asset."

Even conservative bond investors (rather than homebuyers themselves) were persuaded by the fact that "there has never been a nationwide wave of mortgage defaults" and began purchasing leveraged and tranched mortgage-backed securities.

But by 2007, it turned out that housing prices could fall as well as rise, and mortgages expanded based on a perfect historical record were found to have flaws. When real estate and mortgages became everyone’s darlings, they ended up being poor investments.

The truth is, without these so-called truths, those painful bubbles would not have existed.

Mortgages are generally repaid or sufficiently collateralized. The internet may change the world. Oil at $147 per barrel once seemed indispensable and in short supply. But in each case, the advantage was too obvious; the investment idea became so popular that ultimately, asset prices were pushed to dangerous levels.

Following trends that are popular at a given time is clearly not a recipe for successful investment because such popularity might lead investors down a comfortable but wrong path.

Risk and Counterintuitive Principles

If what is obvious or widely known is often incorrect, then what is right?

The answer lies in reversing the concept of obvious appeal.

The truth is, the best purchases always come from what the majority does not understand or believe in—be it securities, investment methods, or investment concepts. However, it is often those elements that are not widely accepted which are spotted by investors who possess the insight and courage to go against the tide.

• Contrarian investment philosophy helps investors achieve continuous success.

Contrarian investment philosophy helps investors achieve continuous success — indeed, the investing public often makes erroneous decisions. Particularly, the higher the price rises, the more aggressive they become; conversely, the greater the decline, the more cautious they grow, acting contrary to what is expected. However, making decisions opposite to those of most investors is not so straightforward. Often, there is no clear imperative to act or refrain from acting.

Contrarian investment philosophy works best in extreme situations and only benefits those who understand what the investing public is doing and why they are wrong. Moreover, these individuals must summon the courage to make opposing decisions.

• Doing what feels right is important.

The most outstanding investors rationally know what actions are correct. But even when such knowledge brings them comfort, they must restrain themselves from following that instinct.

The best ideas often fail to gain recognition from others. As I wrote in my book 'Dare to Be Great,' exceptional ideas are necessarily lonely. By definition, popularity, widespread agreement, or obviousness contradicts the notion of standing out.

Most successful investments initially provoke unease. Good investors are just as susceptible to the same misleading information and emotional influences as others. The difference lies in their superior self-discipline.

• Assets with stronger liquidity tend to be safer.

Greater asset liquidity generally means that it is easier to sell the asset at a price closer to the last transaction. However, first, liquidity may dry up when other investors change their views on the asset. Second, theoretically, the ability to sell an asset when you want to is unrelated to fundamental safety and has relatively little to do with long-term investment security. Investing in assets with solid fundamentals, attractive prices, and thorough analysis is much safer, allowing you to hold them for a long time without considering exit strategies. The best way to avoid a lack of liquidity is to arrange your investments so that there is essentially no need to pursue liquidity.

Should beginners, untrained individuals, or those unwilling to put in effort achieve extraordinary profits? Can above-average returns be achieved without effort, exceptional skills, or access to information unknown to most people? The answer is no. However, many investors proceed based on the belief that they will succeed.

Outstanding investment returns cannot rely on static strategies, widely known methods, stop-loss rules... or avoiding all risks. Only investors with superior abilities who can discern when taking risks will yield rewards and when it will lead to losses can achieve desirable returns. There is simply no other way.

Exceptional skill is an essential factor for achieving consistently outstanding investment results. Without excellent judgment and execution, no strategy or technique can be expected to produce remarkable outcomes. Clearly, only a small fraction of investors possess such superior skills.

Editor/Jayden