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Investors: This Is 1 Thing You Should Never Do

Howard Marks, the co-founder and chairman of investing firm Oaktree Capital Management, may not be very well-known even among the investing crowd. But, he’s one of the most astute market commentators and investors out there.

Don’t just take my word for it – you can look at Marks’ track record. According to Bloomberg, “Oaktree’s 17 distressed-debt funds have averaged annual gains of 19 percent after fees for the past 22 years” as of June 2011.

Meanwhile, this is what Warren Buffett, who certainly is a famous and accomplished investor, has to say about Marks:

“When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something, and that goes double for his book.”

The book Buffett’s referring to is The Most Important Thing and it contains some clever thoughts from Marks about the one thing investors should never do. And that is, to perform first-level thinking.

First-level thinking is, in Marks’ words, “simplistic and superficial… all the first-level thinker needs is an opinion about the future.” Second-level thinking, however, “is deep, complex and convoluted. The second-level thinker takes a great many things into account.”

Here’re some examples from the book about the difference between first-level and 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.”

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 a panic. Buy!””

In essence, second-level thinking digs way beneath the surface. And it’s crucial that investors do so because first-level thinking can result in painful consequences. Really painful consequences.

Consider this. First-level thinking may equate strong economic growth in a country with great stock market returns. But, check out the following tweet from investment manager and blogger Ben Carlson, showing research compiled by AllianceBernstein:

China, with its massive economic growth, saw its stock market shrink in value over a period of more than 20 years from 1992 to 2013. Meanwhile, Mexico, whose economy grew at a nondescript pace, saw stellar stock market returns.

Investors who chase gross domestic product (GDP) growth thinking it’d automatically lead to great investment returns may be flirting with trouble.

Also, consider this. First-level thinking may say “The price of this commodity is going to rise. Let’s buy the stock of the commodity’s producers.” The experience of Australian gold miners shows just how dangerous such first-level thinking can be.

From 30 September 2005 to 15 September 2015, the price of gold in Australia had grown by a compound annual rate of nearly 10% from A$621 per ounce to around A$1,550 per ounce. But, the S&P / ASX All Ordinaries Gold Index, an index for Australian gold-mining stocks, had lost 4% per year, falling from 3,372 points to 2,245 over the same period.

Shares of palm oil companies in Singapore’s stock market – like Golden Agri-Resources Ltd (SGX: E5H) and Bumitama Agri Ltd (SGX: P8Z) – have been hit hard over the past year partly as a result of falling oil-palm prices. According to the Wall Street Journal, crude palm-oil futures had touched a six-year low in late August this year.

Company Share price change from 14 Sep 2014 to 14 Sep 2015
Bumitama Agri -33.6%
Golden Agri-Resources -38.6%

Source: S&P Capital IQ

Investors may be tempted to invest in the shares mentioned above as a means to profit from any bounce in the price of palm oil. But like what we saw with the Australian gold miners, such first-level thinking (“the price of this commodity is going to rise. Let’s buy the stock of the commodity’s producers”) can be a risky way to invest.

More thought has to go into the broth. What are the commodity producer’s all-in production costs? Can the commodity producer’s balance sheet withstand a prolonged period of low prices without being forced to raise equity or sell assets? Is there significant scope for an expansion of production volume for the company? How expensive is the company’s stock now?

Such questions, which are more akin to second-level thinking, need to be answered before any investing decision can be made.

First-level thinking is easy. But it’s not useful for us at all as investors and can potentially lead to dangerous investing conclusions. Stay clear of it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.