Second-Level Thinking: Howard Marks



“It’s not supposed to be easy. Anyone who finds it easy is stupid” – Charlie Munger

Howard Marks, co-founder of Oaktree Capital, developed the concept of second-level thinking and has explained it in detail in his book, The Most Important Thing, his widely publicized memos, and interviews.

According to his book, The Most Important Thing:

“First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.

Second-level thinking is deep, complex and convoluted. 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’s the probability I’m right?
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset comport with the consensus view of the future, and with mine?
  • Is the consensus psychology that’s incorporated in the price too bullish or bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

…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 that of others – both more powerful and at a higher level. 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. 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.”

Examples of first-level thinking and second-level thinking include the following:

  • 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 a memo published in September 2015, Howard Marks shares additional thoughts about second-level thinking in the context of market expectations and inherent shortcomings of first-level thinking in investing:

  • Given how hard investors work to find special opportunities, people who think it can be easy overlook substantial nuance and complexity
  • The investor’s basic goal of buying desirable assets at fair prices is sensible and straightforward. But the deeper you look, the more you see how many aspects of successful investing are counterintuitive and how much of what seems obvious is wrong
  • The things with the most obvious merit become the things that everyone likes. They’re also likely to be the things that are most hotly pursued and most highly priced, and thus least promising and most treacherous
  • The process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely
  • Why should superior profits be available to the novice, the untutored or the lazy?
  • Superior investment results can only stem from a better-than-average ability to figure out when risk taking will lead to gain and when it will end in loss
  • No tactic or technique will lead to superior results in the absence of superior judgment and implementation

Source: The Most Important Thing, Howard Marks Memo (September 2015)

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Image Source: The Travel Channel



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