This past weekend I read through a handy book called The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks. Marks is co-founder of Oaktree Capital Management and the book is a collection of memos he has sent to his clients over the years.
One of the more interesting chapters refers to something he calls “second level thinking.” While first level thinkers might buy a stock because the company is good, a second level thinker will realize that many people already think it’s a great company. Therefore, they realize positive sentiment is already priced into the current value, resulting in an overrated stock that should be sold rather than bought.
Since I predominantly short stocks and bet against companies – you might call me a bear – I’ve been performing second level thinking for years. I just never called it that or realized someone had a term for it.
As a short seller, you have to take many variables into account. It’s not enough to think that a stock is overvalued and that you should short it. That’s first level thinking that will lead to average outcomes.
Marks presents a great checklist regarding second level thinking that I plan to incorporate into my own work. So I wanted to share it with you because I think it could be useful in doing your own investment analysis.
These are the variables he suggests second-level thinkers take into account:
- What is the range of likely outcomes?
- Which outcome do I think will occur?
- What’s the probability I’m right?
- What does the consensus think?
- How do my expectations differ from the consensus?
- How does the current price for the asset comport (or behave) 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?
I think that asking those questions before making an investment, and keeping tabs on them while a trade is in play, can dramatically improve your results!
John Del Vecchio
Contributing Editor, Dent Research