Howard Marks Second-Level Thinking: Level Up!

This article on Howard Marks second-level thinking was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by UggBoy, edited by Broken Leg Investing.

According to legendary value investor Howard Marks, there is something in investing that separates the best from the rest.

That “something” — which we will discuss shortly — begins with the understanding that investing isn’t a straightforward process.

What Is Howard Marks Second-Level Thinking?

In his book The Most Important Thing, Marks explains what makes the basis of what second-level thinking fundamentally means:

“Investing, like economics, is more art than science. And that means it can get a little messy. … One of the most important things to bear in mind today is that economics isn’t an exact science. It may not even be much of a science at all, in the sense that in science, controlled experiments can be conducted, past results can be replicated with confidence, and cause-and-effect relationships can be depended on to hold.”

Marks’ point here is that investing is not — and should not be considered — simple. There is no single formula or rule that one should follow in order to be a successful deep value investor. While certain rules or formulae can point one in the direction of a successful idea, there is absolutely no one-size-fits-all answer to the question: “Where should I invest my money?” Therefore, it takes something additional in order to create a successful value investor.

How You Can Become a Howard Marks Second-Level Thinking Specialist

Knowing that deep value investing is not ever going to be easy and straightforward is the premise upon which Howard Marks second-level thinking is based. However, what does this mean for those deep value investors who wish to actually become successful?

Marks has the answers:

“In my view, that’s the definition of successful investing: doing better than the market and other investors. To accomplish that, you need either good luck or superior insight. Counting on luck isn’t much of a plan, so you’d better concentrate on insight. In basketball, they say, ‘You can’t coach height,’ meaning all the coaching in the world won’t make a player taller. It’s almost as hard to teach insight. As with any other art form, some people just understand investing better than others. They have — or manage to acquire — that necessary ‘trace of wisdom’ that Ben Graham so eloquently calls for.”

So, the definition of successful investing is producing better-than-average returns, and in order to be better than average, you will need superior insight. However, superior insight is difficult to teach — this is why above-average returns are so elusive.

This all leaves us with the same burning question — if superior insight is so difficult to achieve, how can we expect to be able to achieve it?

Adopting Superior Insight

Marks, again, sheds some light for deep value investors to consider:

“In some pursuits, getting to the front of the pack means more schooling, more time in the gym or the library, better nutrition, more perspiration, greater stamina or better equipment. But in investing, where these things count for less, it calls for more perceptive thinking … at what I call the second level. … Would-be investors can take courses in finance and accounting, read widely and, if they are fortunate, receive mentoring from someone with a deep understanding of the investment process. But only a few of them will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results. Doing so requires second-level thinking.”

The answer to the question that Marks poses — and the key to Howard Marks second-level thinking — is an almost divine, high-level approach to thought. If one can “simply” achieve this higher-level thinking, they are more likely to be able to achieve second-level returns. What Marks means by higher-level thinking is the ability to think of things that others have not, see things that others fail to see, and react differently to events.

Fortunately, since you are reading this, you are already at least interested in the teachings of deep value investing. This automatically makes you a different breed of investor — one who is better suited to the Howard Marks second-level thinking way. While we now have a decent idea of what it takes to be a second-level investor, it would be useful to get a clearer indication of how we can help ourselves to be one.

Howard Marks Second-Level Thinking: An Example

With the help of a detailed differentiation, Marks can help us with this:

“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 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:

As we see, rather than being something that we can just switch on, second-level thinking is something that we must learn to do. By gradually changing the way we think about investing, we can become second-level thinkers — and thus, better deep value investors.

However, as Marks suggests, in order for someone to become a second-level thinker, they must be willing to open their minds to the psychological approach required of Howard Marks second-level thinking practitioners.

One way to do this is reading. Everyone can read, but the combination of reading, willingness, and ability to apply oneself is not held by everyone.

This is what gives you, the reader of this article, a distinct advantage over the rest of the population. The very fact that you have made the effort to discover this newsletter, and bother to read it at all, makes you a cut above the rest of the investing community — and closer to the status of a second-level thinker.

A Cut Above the Rest

Marks signs off his discussion on second-level thinking with these words:

“Those who consider the investment process simple generally aren’t aware 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 to second-level thinkers. To consistently achieve superior investment returns, you must be one of them.”

This is an uplifting message for any value investor. Because not everyone can become a second-level thinker, the potential returns available to those who achieve this status are far greater. This is the same as saying that one can only achieve above-average returns if they think and behave differently — otherwise, they are just going to achieve the average result.

The message of this article, therefore, is that if you want to perform better than the average investor (the market), then you must think differently from the average investor. You must be smarter, more critical, more aware of the market’s (and your own) biased thinking, more of a contrarian, and willing to play the role of devil’s advocate. If you can do all of these things, you too can be a great practitioner of Howard Marks second-level thinking — and the ultimate deep value investor.

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