Second Level Thinking: The Key to Earning Alpha in Investing

Thinking like the rest will inadvertently produce average results.

What is the goal of active investing?

Assuming we’re talking about stock market investing, the goal of active investing is simple – to beat the index. Others might say they actively invest merely as an intellectual exercise, but I would remind them that there are plenty of other ways to exercise your mind without the risk of losing money.

Beating the market index is hard. Much harder than people tend to think. In fact, most investment managers do not beat the stock market after fees in the long run. I will talk more about this issue and why index investing is the logical option for most in a later article. 

Index investing gives us average results. Average results compounded over a long time can bring us vast amounts of wealth. 

But let’s say you don’t want to be average. 

Perhaps you want what people call “alpha”. In investing, alpha means excess returns in comparison to the stock market index. For example, if the index (say the MSCI World Index) returns 7% in one year and you earn 9% while taking the same amount of risk, your alpha is 2%. 

The problem is that every other active investor is also shooting for alpha. Thus, the pursuit of earning excess returns compared to the market average is a zero-sum game. What makes you think you can win?

Howard Marks, one of the greatest investors of our time, claims that beating the market requires what he calls “second level thinking”.

The name second level thinking implies that there’s also something called first level thinking. So what is second level thinking and what makes it different from first level thinking?

First level thinking merely requires a view of the future. 

Second level thinking takes many other factors into consideration. 

• What is the consensus outlook for the future? 

• What is my outlook for the future? 

• Does my outlook diverge from the consensus? If so, what makes me think I am right? 

• What is the probability I am right? 

• How will I find out if I am wrong?

• Are the consensus estimates already reflected in the price?

Second level thinking is deep, sophisticated, and insightful.

• The first level thinker says, “the outlook for company A for the next three years is good. Let’s buy.” The second level thinker says, “the outlook is good, but everyone else thinks the same, thus it is already reflected in the prices. I’ll look for other opportunities.”

• The first level thinker says, “the economic environment is the worst it’s ever been since 2008 and I see no sign of hope in the near future. Sell.” The second level thinker says, “the economy is disastrous but people are overly pessimistic. If I start building a position now, the probability of buying cheap is high.”

To put it simply, the second level thinker asks, “and who doesn’t know that?” before making an investment decision. Forgetting to ask this simple question is what causes people to participate in the worst of bubbles and shy away from the best of opportunities. 

Like the first level thinker, the second level thinker also holds opinions on what the future will look like. Both do everything in their power to find the right answers. But the second level thinker understands that merely being right is not enough. To strive for superiority, you have to think differently and be right. 

Second level thinkers know that holding the consensus view will bring about consensus returns. They recognize that it doesn’t matter how detailed the research is or how complex the models are if they agree with everyone else. To have results that diverge from the average, one must hold opinions that diverge from the crowd.

To be clear, holding a different view from the rest only guarantees a result that diverges from the average. This divergence can be positive or negative. If your opinions diverge from average and you are right, you will earn excess returns. If your opinions diverge from average and you are wrong, you will incur excess losses.

Opportunities to be different and right are rare. The second level thinker acknowledges this and only acts when the probabilities of being different and right are overwhelmingly in their favor.