The “Second-Level” Rule: How To Think Like A Pro Investor (From An Expert)

If you’re unclear as to what drives the markets, join the club. Most people, even casual “investors,” don’t get it. In particular, I’m talking about stocks, bonds, or any asset that can be efficiently traded (what I mean by “efficient” here has to do with how quickly you can exchange the financial asset for cash and vice versa –- as in: NOT your house, car, or your business) in order for you to be successful. What you need to understand on a bone-deep level is something Howard Marks of Oaktree, a genius in the bond market, has talked about repeatedly in his memos.

It’s called: Second-Level Thinking.

(I’ll break down exactly what this means in a minute.) But first, a little context. The market is filled with smart people…people who estimate values and markets and trade stocks and bonds for a living: mutual and hedge fund managers, strategists, economists, etc. They’re all trying to make a bigger buck than the average person through their trades. When you get into hardcore investing, you quickly understand this basic, brutal truth: in order for me to kill it and make cash, someone has to eat it and lose cash. (This does not mean we have to screw each other over to get ahead; but, in professional investing, winning the game IS all about making better decisions than your peers so that you can make a future financial profit that would otherwise have been someone else’s gain.)

Your goal is to buy an asset for really cheap, at someone else’s expense. The reality for professional investors is: for every buyer, there’s a seller. This is the way of the world, but it’s especially crystal-clear when you make your living by investing.

So: Howard Marks starts his recent blog post with a quote from Charlie Munger (another great investor) about investing in the markets:

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

If there are so many smart people trying to gain outsized returns in the market, you can understand why that would minimize the overall opportunities for excess returns. Everybody’s competing for profits, so there is less profit to go around! The price inefficiencies (aka, where you can make a buck by buying an asset cheaply from one yuk-yuk and selling it for a higher price to another yuk-yuk) get reduced, because as soon as people realize there’s a resale opportunity, everyone dog piles and starts doing the same thing. Over time, this dynamic increasingly reduces the individual investor’s ability to make a profit. Hence investors’ inside joke: “There’s no free lunch, son.”

Achieving average, long-term profit results is easy enough through an index fund or an ETF (Exchange-Traded Fund). In fact, I would highly recommend these portfolios for all of you out there starting down the road of investing and properly planning your finances. They’re lower-risk ways to build your capital over a lifetime. However, for the readers who aspire for more immediate, larger margins of profit, you need to understand this: the market is priced to ultimately reward Second-Level Thinkers.

What do I mean by this? Let me return to Marks:

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 good company, and its future may not be as rosy as its past. So, the stock’s overrated and overpriced; let’s sell.”

First level thinking says, “I think the company’s earnings will fall; let’s sell.” Second level thinking says, “I think the company’s earnings will fall far less than people expect, and the pleasant surprise will lift the stock price; let’s buy.”

So, First-Level Thinking is exactly what it sounds like -– simplistic and superficial (it only considers the first effect, the first layer of the market, the first course of action). It’s single-plane thinking. Very seductive, because the “first thought” itself is…true. And this is how most average investors get squashed on the highway that is investing: market prices of a security (like a stock or bond) already reflect the First Level of Thinking –- it’s priced in. So, if you’re buying shares of a company based on something really obvious (like, “Apple is a great company. I like Apple, and I think other people do too”) you’re correct, my friend: but the trade may not work the way you expect it to.

In First-Level Thinking, you’re ignoring the part that other investors play in how prices change.

It’s quite a different level of thought process to say, “Apple is a great company, and people are really worried about how the slowdown in China will affect their mobile phone sales, so the stock price has been punished. But China is going to be a small percentage of their future growth; I’ll buy.” Second-Level!

This is just an example of how long-term winners in the markets think on the Second Level. If something is obvious to you and all of your friends, the price of the company’s shares already reflect this obvious quality.

Picking your near-term entry points and exit points for investing by following the herd is a tried-and-true recipe for investing failure.

So, the next time you pick up the phone to talk to your financial advisor after reading an article in The New York Times about a company or the economy, put that phone down and ask yourself, “Am I about to show my First-Level thinking chops, or can I ask the Second-Level questions that will truly contribute to the discussion at hand?”

Popular opinion surrounding an investment (“Apple is valuable”) eliminates its profit potential (because it makes investors dog-pile and eliminate the relate profit margin). Those are the facts!

Jane Hwangbo is a former investment analyst and portfolio manager who founded Money School with Jane, a personal coaching program designed to change the way individuals see and interact with money. Visit her website or find her on Twitter.

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