Second-Level Thinking: What Is It And Why You Need It

Understanding the numbers is just one part of investing. To be a successful long-term investor, you need not only understand the numbers but also the psychological traits required to be able to capitalise on your analysis.

Personally, I believe that understanding psychological drawbacks/benefits of investing is more important than being a numbers person. If you can’t control your emotions, no matter how much work you put into researching an opportunity, it will all be for nothing.

Howard Marks, the CEO, and founder of Oaktree Capital believes that to be a successful investor, you have to master something called “second-level” thinking to master your emotions.

The idea of second-level thinking

In one of his memos to Oaktree Clients in 2015 titled “It’s Not Easy,” Marks explains that if you believe investing is easy, you do not understand one of the critical functions of markets; to eliminate opportunities for excess returns.

Marks writes, “In most markets transparency needs to reveal and thus preclude obvious mispricing’s (thanks to the incredible gains and access to data by way of the Internet, this is certainly more true today than ever before.)

This is where second-level thinking comes into play. Second-level thinking is the requirement to think better than others, at a higher level, finding an edge not available to the remainder of the market. As Marks puts it, “You have to think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have two react differently and behave differently.

“First-level thinkers see what’s on the surface, react to it simplistically, and buying or sell on the basis of their reactions. They don’t understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all of this for the route to success.”

For instance, if a first-level thinker is saying “it’s a good company, let’s buy the stock,” second-level thinking will interpret this as “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.

If first-level thinkers believe the company’s earnings will fall, second-level thinking says, “I think the earnings will fall far less than people expect.

Second-level thinking is not only contrarian in nature, but it should seek to ask why I should have a different view compared to the rest of the market and what is likely to be the alternative outcome(s).

Understanding the psychology

Most people are not born with the ability to think in this way. It’s human nature to want to fight or run (fight or flight). This is no bad thing, self-preservation is, after all, the reason why the human species has evolved to where it is today. However, if you’re going to try and beat the rest of the investment world, you need to understand the requirement to think differently.

The first stage in this process is just knowing that second-level thinking is required. By controlling your emotions, taking a step back and taking time to think before making a trading decision, you’re halfway there.

Personally, to help me avoid these issues, I use a checklist. I don’t make a trading decision until I’ve had time to evaluate the opportunity (either buying or selling) against my list and I only make a trade if all the boxes are ticked.

There are four primary goals of this process.

  1. It forces me to take a step back. If I see a cheap stock and want to buy it, going back to the checklist (usually a day or two after) allows me to look at the opportunity with a more objective view.
  2. It forces me to use a process. I built my checklist using the mistakes of the past. Reviewing it now helps me to avoid repeating past mistakes and makes me use a process to find the true value, not value traps or stocks that just look cheap.
  3. It removes emotion. Falling in love with a company is easy. You might like the product, know someone that works there or want to follow a well-known investor into the trade. But that does not mean it’s a great investment. On more than one occasion I’ve found myself looking at a stock, loving the business but then going through the checklist to find underlying problems I don’t want to be part of.
  4. It helps reduce risk. The best way to reduce risk is to understand what you’re buying. Not only will you avoid the worst stocks but also, in a bear market, if you really know and understand the business you own, the drive to bail out if the stock falls 50% should be significantly reduced.

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