Thinking It Through

Is first level thinking harmful to your portfolio?

2023 was a perfect example of how important it is to monitor price action and its behavior relative to your thesis. I’m no stranger to overcomplicating things. Sometimes I can’t help it. I want to feel smart or justify the time and energy I put into analyzing markets/portfolios. Legendary investor and founder of Oaktree Capital Management Howard Marks’ 2011 book, “The Most Important Thing” discusses first and second level thinking. I’ll summarize but go read the book if you haven’t - one of the best.

First level thinking is very straightforward. If the asset’s price is going up and earnings are growing, buy it. Don’t think too much, just keep it simple. First level thinking is not “What if” but rather “What is”.

Second level thinking is more complex. You evaluate the range of potential outcomes, compare your view to the consensus, and understand that asset prices are a reflection of the collective expectation of participants. It is more elaborate than first level thinking - but Howard Marks argues it is a required skill to become a superior investor.

When most investors (including Howard Marks) compare the two, they will label first level thinking as harmful to your portfolio and second level thinking as required in order to realize above average returns. I agree that second level thinking is important, we must weigh probabilities and assign a path of least resistance. However, I believe first level thinking is also a skill that when applied correctly, can greatly benefit your portfolio.

Hear me out, I’m not disagreeing with Howard Marks. God knows he is 100x more intelligent than myself. I agree, second level thinking is what separates great from average investors. I just think he didn’t give first level thinking an honest cut.

In today’s world it is very easy to overthink and overcomplicate things. We have so much data at our fingertips, its easy for investors to reach analysis paralysis. I believe it’s a real skill to tune out some of this and focus on the variables that matter most. For me that’s price. Price is what pays us - not an elaborate view on what will happen…eventually…if X, Y and Z materialize. I think that at times, good first level thinkers have an edge in the market. They are hyper focused on one investing approach, they follow strict but simple rules and aren’t dependent on being right more than once.

By applying second level thinking to Howard Marks’ concept of first level thinking, I’ve come to the conclusion that effective first level thinking plays a role in turning average investors into great investors.

Alright, that’s enough out of me. Disagree? Reach out and tell me why.

This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results. Please contact your financial professional for more information specific to your situation.