Howard Marks on second level thinking & beating the market

Howard Marks is the Chairman and cofounder of Oaktree Capital Management and author of The Most Important Thing: Uncommon Sense for the Thoughtful Investor. According to the book’s sleeve, he is renowned for his insightful assessments of market opportunity and risk. He is sought out by the world’s leading investors, and his client memos brim with astute commentary and time tested fundamental philosophy. On a more personal note he’s one of my investing heroes. A value investor at heart, his broad thinking and eloquent expression is pertinent to anyone with investment and business interests both professional and personal. Marks is also well known exponent of second level thinking, and it’s importance in being able to beat the market as an investor. I’ve summarised his explanation of second level thinking here.

How to beat the market with second level thinking

On the basis that anyone can invest in an index fund and achieve market returns, Marks views the definition of investment success as being the ability to ‘beat the market’. To accomplish that, you need either good luck or superior insight. However, counting on luck isn’t much of a plan, so his advice is to concentrate on insight. And since other investors may be smart, well-informed and highly computerised, you must find an edge that they don’t have. Marks provides a simple matrix that positions second level thinking:

He also provides a list of the great many things that a second level thinker should take 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 into 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?

On being a contrarian and holding non-consensus views

The upshot is simple: to achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be right. That’s not easy… 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.

In business, and life in general, ultimate success often lies in combining unconventional behaviour with favourable outcomes; the need to think and act like a contrarian. After all, logic dictates that if you follow the crowd then you can’t beat the crowd. As Marks says:

You must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.