Investment Thinking Must Be Unique
To maintain returns above average, one requires exceptional insight, intuition, a sense of value, and an understanding of market psychology. To achieve this, one needs second-order thinking.
Doing the right thing might be a necessary condition for successful investing, but it is not a sufficient condition. You must do more right things than others, which means your way of thinking must be unique.
What is Second-Order Thinking?
- First-order thinking says: “This is a good company, so buy this stock!” Second-order thinking says: “This is a good company, but everyone thinks this company is good, so it isn’t a good company. This stock is overvalued, the market price is too high, so sell!”
- First-order thinking says: “From a forward-looking perspective, economic growth is sluggish and inflation is rising, so sell the holdings!” Second-order thinking says: “The economic outlook is terrible, but everyone is selling stocks out of panic, so we should buy!”
- First-order thinking says: “I believe this company’s earnings will decline, so sell!” Second-order thinking says: “I believe the decline in this company’s earnings will be less than expected; an unexpected surprise will push the stock price up, so buy!”
What Second-Order Thinkers Consider
- What range of outcomes might occur in the future?
- Which outcome do I believe will occur?
- How high is the probability that my view is correct?
- What is the market consensus?
- How large is the difference between my expectation and the market consensus?
- How closely does the market price of this asset align with the price believed by the market consensus?
- And how about the price according to my view?
- Is the consensus sentiment reflected in the price overly optimistic or pessimistic?
- If the market consensus proves to be correct, what impact will that have on the asset price?
- If my expectation is the correct one, what impact will that have?
There is a clear and significant difference in the workload between first-order thinking and second-order thinking. The number of people capable of second-order thinking is clearly much smaller than the number capable of first-order thinking. First-order thinkers look for simple formulas and easy answers. Second-order thinkers know that successful investing is contrary to simplicity. This doesn’t mean you won’t encounter many people who try to make investing sound simple, which I call “mercenaries.” Brokerage firms want you to believe that everyone is capable of investing, and that every trade only requires ten dollars. Fund companies don’t want you to believe that you are capable of investing, but they want you to believe that they are capable of investing, so you will put your money into actively managed funds and pay higher management fees.