Benjamin Graham wrote this in The Intelligent Investor…
The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom.
The ironical truth about investing is that, despite hundreds of rules that guide the practice of being an investor, there is no rule that works all the time, and in the same manner.
Investing is, after all, not like a game of football where the ground and the ball remain the same throughout the ninety minutes of play. It’s more like cricket where the pitch changes its behaviour with every new ball, and the ball changes is shape every time it’s bowled.
So, when you are an investor, the environment in which you play isn’t controllable, and circumstances rarely repeat exactly. What’s most important then is how you behave when others are behaving oddly.
One of the best tools to think and behave better in investing is what Howard Marks calls…
Second Level Thinking
Here is what Marks writes in his seminal book, The Most Important Thing…
- 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!”
- First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.
In other words, first-level thinking, as the name suggests, is what comes to our mind first. And given that our mind is searching for simplicity, in most cases, this kind of thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority, like in investing).
Sadly, we appear to be hard-wired to accept things at face value, which fosters first-level thinking.
In fact, evidence suggests that in order to understand something we have to believe it first (first-level thinking). Then, if we are lucky, we might engage in an evaluative process. This is true of the stock analysis process as well.
We first like a company and only then try to evaluate why we like it! So a lot of biases are at work while we are analyzing businesses – their financial statements or moat characteristics.
We create stories around business. Stories like…
- Page Industries will be a multi-bagger from any price
- Nestle has risen by 80x in 10 years, so it’s always a wonderful stock to buy
- Infosys will consistently maintain a 30%+ ROE
- L&T will always be the best Indian engineering company to invest in
And then we work around our analysis to try and prove that the stories that we believe in are true.
So, while the “rational way” to business analysis is…
What most of us practice is the “story way”…
Howard Marks says that first level thinking is simplistic and superficial, just about everyone can do it. All first level thinking needs is an opinion about the future, as in “the outlook stinks, call for low growth and rising inflation, let’s dump our stocks”.
Second level thinking goes deep. The second-level thinker takes a great many things into account:
- What is the range of likely future outcomes?
- Which outcome do I think will occur?
- What does the consensus think?
- How does my expectation differ from the consensus?
- Is the consensus psychology that’s incorporated in the price too bullish or bearish?
Moving on from being a first-level thinker to the second-level is clearly a lot of hard work.
Having said that, the first step to investment success is to recognize what is needed to be done i.e., second-level thinking in this case. The second step is to start exercising this kind of thinking into our investment process.
If you wish to perform better than the rest of investors – or in other words, perform better than average – your thoughts, actions, expectations, and portfolios have to diverge from the norm i.e., seeing, then believing, and then evaluating.
Most importantly, you don’t have to be just different, you also must get it right…not 100% of the times, but it’s good to aim for a distinction…that is 75%. And for that, you need to practice second-level thinking.
Practicing first-level thinking or believing everything you see and read of a business is a big sin.
To conclude, here’s something more from Marks on the need for second-level thinking…
Those who consider the investment process simple generally aren’t award 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 for second-level thinkers. To consistently achieve superior investment returns, you must be one of them.