Edward Quince (EQ): Howard, given how easy it is to access data today, many investors believe they are intellectually superior. You argue that true superiority requires a concept you call "second-level thinking". What is the core distinction between first-level and second-level thinking?
Howard Marks (HM): Superior investing isn't easy. Anyone who thinks it is must be a first-level thinker. First-level thinking is simplistic and superficial, such as looking for the highest-quality company, the best product, or the fastest earnings growth, without considering the price or investor perception. Second-level thinking is deep, complex, and requires you to think differently and better than the consensus.
EQ: Can you give us an example of how this applies to fundamental analysis?
HM: Certainly. A first-level thinker says: "That's a great company; we should buy it". A second-level thinker asks: "It is a great company, but everyone agrees, so its valuation is sky-high. If anything goes wrong, the stock will plummet. I'll avoid it". For your performance to diverge from the norm, your expectations—and thus your portfolio—have to diverge from the norm, and you have to be more right than the consensus.
EQ: This seems tightly linked to contrarianism. How important is resisting the herd mentality to achieving long-term success?
HM: It is essential. Contrarianism means consciously looking for things others haven’t recognized. Since the consensus view of the future is already embedded in the price of an asset, to bring above average profits, a forecast generally must be different from the consensus and accurate. We believe strongly in contrarianism. That means leaning away from the direction chosen by most others: Sell when they’re euphoric, and buy when they’re afraid.
EQ: Acting against the crowd takes courage, especially since there is often a period where following the herd seems smart, and the abstainer looks foolish.
HM: That period of underperformance is inevitable, but the roles are inevitably reversed in the long run. You must be able to stand by your non-consensus view, even if the early going suggests it’s wrong. Ultimately, superior investing requires not just possessing data, but drawing superior inferences and applying second-level thinking. We must recognize that the market will only be permanently efficient when investors are permanently objective and unemotional—in other words, never. This imperfection provides the opportunity for skill to outperform.
The Edward Quince Takeaway
To achieve superior results, you must engage in second-level thinking: being different and being better than the consensus. Recognize that opportunities exist because other people have made mistakes. Dare to be a conscious contrarian, buying what others hate and selling what others love, because following the herd ensures average results at best.
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