Regular readers know I often express myself in tones of varied skepticism. While I admit this tendency comes naturally to me, you should know it serves a deeper purpose. Let me briefly explain.
There is something inherently comforting when things sit in a state of balance. In investment markets, however, things are constantly in a state of flux, to one degree or another. Given this, an intelligent investment management process is often lonely and rarely involves broadly following the crowd. Skeptical investors love to ask questions and test the consensus view.
Influential investor and market thinker, Howard Marks of Oaktree, recently wrote about what he refers to as first-level and second-level thinking. His memo did a nice job of highlighting a concept that helps to explain why I feel a healthy sense of skepticism is beneficial as an investor.
First-level thinking tends to reflect the obvious facts already in the news. China’s slowing, commodity prices are down, sell oil stocks, avoid multinational companies and own the US dollar. With gas prices so much lower now and with interest rates still so low, buy consumer-oriented stocks that cater to domestic shoppers.
Now, a second level thinker, in reaction to a first-level thought, might sound very different. Yes, energy and commodity prices are down a ton and it does look like China is headed toward a rough slowdown. But, US oil and gas producers are busy lowering their costs and are finding ways to innovate. With their stock prices down so much and – as long as their balance sheets can hold up – I think they’ll make it through this down cycle. These companies might now be trading at bargain levels.
First level thinkers tend to feel more confident with validating information. It creates a comfortable emotional feedback loop as it follows a seemingly, logical, straight-line relationship. As their confidence builds, they seek safety in the crowd. Soon, ever larger numbers of investors adopt the same comforting view. And, over time, it becomes the consensus view of far too many investors.
The second-level thinker can appear allergic to the consensus view of the day. As uncomfortable as it can feel, second-level thinkers know that following the consensus is not how money is made or how losses are avoided in investment markets. Actually, just the opposite tends to be true over time.
Second-level thinking can appear counterintuitive and can come across as skeptical or stubborn and can be viewed as somewhat pessimistic. Instead, I’d argue that second level thinking is inherently optimistic about the fact that – because things are always changing and are never in balance – great opportunities are always around the bend.
So, the next time you look at your portfolio or begin to make an investment decision, ask yourself if you are making a first- or second-level decision. And, if the decision feels a bit tough or uncertain, you’ll very likely have a good idea.
