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Second Level Thinking, Value Investing is Not For Everyone...

Few people have what it takes to be great investors. Some can be taught, but not everyone … and those who can be taught can’t be taught everything. Valid approaches work some of the time but not all. And investing can’t be reduced to an algorithm and turned over to a computer. Even the best investors don’t get it right every time. The reasons are simple. No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness. 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. -“WILL IT WORK?” MARCH 5, 2009 Because investing is at least as much art as it is science, it’s never a goal to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic. At bottom, it’s a matter of what you’re trying to accomplish. Anyone can achieve average investment performance—just invest in an index fund that buys a little of everything. That will give you what is known as “market returns”—merely matching whatever the market does. But successful investors want more. They want to beat the market. SETH KLARMAN: “Beating the market matters, but limiting risk matters just as much. Ultimately, investors have to ask themselves whether they are interested in relative or absolute returns. Losing 45 percent while the market drops 50 percent qualifies as market outperformance, but what a pyrrhic victory this would be for most of us.” Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Thus, your thinking has to be better than that of others—both more powerful and at a higher level. Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others … which by definition means your thinking has to be different. What is second-level thinking? • 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.” JOEL GREENBLATT: “I hear first-level thinking from individual investors all the time. They read the headlines or watch CNBC and then adopt conventional first-level investment opinions.” • First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!” • First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.” 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: • 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 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? First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results. All investors can’t beat the market since, collectively, they are the market. Before trying to compete in the zero-sum world of investing, you must ask yourself whether you have good reason to expect to be in the top half. To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?

Source: Howard Marks, The Most Important Thing Illuminated

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