Second Level Thinking

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November 13, 2021

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Strategic Alpha

It is important to have what is known as second-level thinking in order to succeed in investing. First-level thinking is simplistic and easy. It is also superficial. Many first-level thinkers don’t know what second-level thinking is. The difference between first-level thinking and second-level thinking will be clear with some examples.

Examples of second level thinking

First level thinking says, ‘Since it is a good company, let’s buy the stock. Second level thinking says, ‘Since it is a good company, everyone seems to be interested in it. Hence, it is possible that it is overvalued. Hence, let’s sell the stock’. For instance, at the peak of the dot com bubble in the late 1990’s, everyone was interested in internet stocks. A first level thinker would have bought the stocks in the bubble and would have made losses when the bubble burst. On the other hand, a second level thinker would have thought that since everyone is interested in IT stocks, they would be overvalued. Hence, he would have sold IT stocks.

First level thinking says ‘In the future, the outlook will be of high inflation and low growth. Hence, let’s go ahead and sell stocks’ Second level thinking says, ‘The future outlook is bad. But, everyone might be selling. Hence, let’s move ahead and buy stocks.’ For instance, when the crash in March 2020 happened, many first level thinkers would have sold stocks as the outlook called for low growth and the risk of covid was high. However, second level thinkers would have said, ‘Everyone is selling in panic. So, stocks are available at cheap valuations.’ Hence, let’s buy stocks.’ The first level thinker would have exited in losses, while the second level thinker would have made good profits as the Sensex has risen by more than 100% since the crash happened.

Need for second level thinking

‘It’s not supposed to be easy. Anyone who finds it easy is stupid.’ – Charlie Munger on investing

According to Howard Marks, those who find investing easy are first level thinkers. But, according to him, first level thinking has a number of flaws. Second level thinking is superior to first level thinking.

Investors need to generate returns over and above the market returns. If an investor’s thinking is average, the returns generated by him would be average. The only way to generate alpha is to have thinking and skills over and above the average. This second level thinking would help him generate these returns in excess of market returns.

How to develop second level thinking?

One of the most important things second level thinkers do is to ask questions. They think about the range of outcomes. While looking at potential outcomes, they don’t discount any outcome at the outset. They think over it. Critical thinking is another important skill. Finally, it is important to practice second level thinking, in order to make it a habit and make better decisions.

Why do people indulge in first level thinking?

It is clear that second level thinking offers a number of benefits. But, people keep indulging in first order thinking because of certain reasons. First level thinking is simple, while second level thinking requires hard work. People have been programmed to do first level thinking, while second level thinking is not taught. Also, since first level thinking is habitual, people continue that habit because it is comfortable.

Myths in Investing

One myth is that low priced stocks necessarily make for good investments. A cheap (low priced) stock does not necessarily mean that it is a good stock. The reality is that the price has to be lesser than intrinsic value for it to be a good investment.

The other myth is that the market is efficient. The efficient market theory assumes that share prices reflect all the available information and hence there are no deviations from intrinsic value. The reality is that some stocks are available at lesser than or greater than their intrinsic value. The reason for this is that stock prices reflect the emotions of market participants such as greed and fear. Stocks, which are available at lesser than their intrinsic values, make for good investments. 

Another myth is that assets which have higher liquidity are safe.  But, liquidity can reduce if market participants change their mind about the asset. Hence, it is important to invest in assets that have sound fundamentals and are also available at cheap valuations. Also, it’s important to analyze a stock well before buying it.

What about broad consensus?

In many cases, there is a consensus about the direction of the market or particular stocks. But, a lot of times, buying something that everyone likes may not work in investing. If everyone likes a stock, it is probable that the stock has had too much capital flow into it due to which it has become overvalued. It is also possible that the performance of stock up to now has been taken from future performance. Also, there is a risk in stocks that everyone likes that if the market participants change their view, they will exit the stock. For instance, everyone liked Nifty Fifty companies in the USA in the late 1960s, leading to excessive valuations. Investors used to think that nothing could go wrong in these companies. But, in the 1970s, the stock returns from these companies were marginal. Here is a fall in IT stocks, which everyone liked in the late ’90s, once the dot com bubble burst in 2000.

To conclude, great returns are not made while buying what everyone likes. They are made by buying what stocks everyone is underestimating. It is important to dig deep and not necessarily look at what is popular. 

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The author of the blog Mr.Suyog Dhavan is a Full-time Investor / Value Trader and Value investing/Trading Mentor. His style of Investing is inspired by Mohnish Pabrai, Peter Lynch, and Porinju Veliath. He is the founder of Strategic Alpha Wealth, A Premier stock market mentorship firm with a mission to touch the lives of 1Lakh people through its mentorship program.

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