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Why Second Level Thinking Is Important In Investing

Investing is a process which can sometimes seem counter-intuitive – the most obvious facts do not always lead to the best investment outcomes. The at-times counter-intuitive nature of investing makes it confusing and perplexing, and this article explores why second-level thinking (a concept mentioned by the value investor Howard Marks) is so important when looking at investment ideas.

First-level thinking

What exactly is second-level thinking? We can start by defining what first-level thinking is: Obvious signs which we observe as investors, and the tendency to immediately conclude without further and deeper thought.

As an example, an investor may see an announcement from Company A about a profit warning for its next quarter, and conclude that its share price would dive as a result. Or, the same investor may see Company B report a sparkling set of earnings with revenue up 50% and net profit up 80%, and assume that the share price of Company B would soar as a result of its splendid results.

The above examples illustrate how quickly people reach conclusions on things which seem obvious on the surface, but which may not be so in reality.

Second-level thinking

Second-level thinking involves a deeper thought process and questions the original assumptions to see if they are indeed valid. Using the above examples, a profit warning may indicate that the worst is over for Company A, and investors may perceive that things can only get better, therefore the stock price of Company A would rise. Company B, which reported the great set of results, may actually be under-performing analysts’ lofty expectations of 100% profit growth, and its share price may plunge as a result.

Second-level thinking is nuanced and has many different facets, therefore it is not an easy task. But in order to be able to have an advantage in the market, we must be able to think deeper in order to discern if a piece of news or corporate development is as good or bad as it appears to be.

Marks said it well when he remarked that not many investors make the effort to think beyond the first-level, and this is because people are either lazy, or incapable of understanding the myriad implications relating to information disseminated through the stock market. By taking time to think more deeply on issues and to sift through the layers, an investor who practises second-level thinking can gain profound insights which may elude other investors.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.