FREE NEWSLETTER
“WHO DOESN’T KNOW that already?” That’s the question we should ask when making an investment decision.
Take Tesla. It builds wonderful cars. It’s an innovative company led by a visionary CEO. Its sales are growing by leaps and bounds. Question: Who doesn’t know that already?
If the attributes of a company are widely known, more than likely its stock price reflects that. The question for investors isn’t whether Tesla is a great company. Rather, the question is whether Tesla is a great investment. Two very different things.
Famed distressed-debt investor Howard Marks discusses this notion in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. First-level thinking is commonplace, second-level thinking far less so. In Marks’s words, first-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
Second-level thinking requires an appreciation of intrinsic value. In the words of Warren Buffett, “Price is what you pay; value is what you get.” Conflating the two is a common mistake of first-level thinking.
Second-level thinking is probabilistic thinking. So much of investing is about the future and hence uncertain. It isn’t easy to simultaneously hold a variety of scenarios in our mind and assign probabilities to each. But that’s what second-level thinkers must do. Second-level thinkers are also like world-class poker players, adept at appraising their opponents. They understand the importance of investor psychology and the way it shapes the investing climate. Consider some examples of first- and second-level thinking.
First-level thinking: The economic data suggest the economy is slowing, maybe even headed into a recession. The Federal Reserve is intent on raising interest rates, which will be a further headwind. Time to sell stocks.
Second-level thinking: The possibility of a recession looms, but stocks have already fallen quite a bit. While there may be further downside, investors are forward-looking and stocks have already priced in a mild recession. Moreover, while a recession is possible, it’s not a foregone conclusion. Time to start buying.
First-level thinking: China is a mess. A renewed lockdown has wreaked havoc on its economy. GDP growth is at multidecade lows. Recent crackdowns by Beijing remind us that the rule of law is tenuous. Avoid investing in China at all costs.
Second-level thinking: Yes, China is a mess. Yes, economic growth has slowed sharply. But all this is widely known and has been priced into Chinese shares. Historically, there’s been a low correlation between a country’s GDP growth and its stock market returns. Investors have scant enthusiasm for Chinese and other emerging market stocks. As a result, emerging markets are dirt cheap relative to U.S. stocks. It’s time to raise our allocation to emerging markets.
First-level thinking: The war between Ukraine and Russia has led to soaring energy costs across Europe. Inflation and geopolitical uncertainty are major threats. It’s time to sell. Once the dust settles, I’ll buy back into European stocks.
Second-level thinking: There’s great uncertainty in Europe. But this has been reflected in falling stock prices and a weakened euro. There’s a danger the conflict widens, which would likely mean further losses for stocks. But this uncertainty presents a long-term buying opportunity. By the time the dust settles, share prices will be much higher. Start buying European stocks today.
The first-level discussion centers on “the market has already priced in” near-future performance. A second-level view would be to look for value that the market has not priced in (yet), little known companies or advances in technology. In the 1980’s Peter Lynch averaged double the S&P by visiting small and mid-sized companies to see them first hand.
First-level thinkers let current events drive their investment decisions.
Second-level thinkers look ahead to what is most likely to transpire in the future. Markets run in cycles and all recessions eventually end. Are there investment bargains available now that I should consider?
An investment pundit once said that the only good investment is one purchased at the right price. Hint: You’re not likely to find investments at the right price in a bull market.
Both the first- and the second-level thinking examples are examples of market timing which Buffett is strongly against. In this day and age, there are millions of investors who are aware of the basics of behavioral finance. This makes me very skeptical of the notion that level-one thinking has a much stronger impact on market prices than level-two thinking.
While not exactly market timing, there have been several instances of Buffett buying large quantities in downturns. He certainly didn’t try to time the market bottom but on the other hand he knew he was getting greater value for each dollar spent.
It is so easy to over-think investing choices.
That Buffett quote gets at my strategy now for buy decisions with new cash: where are measures of value today vs long-term and modern averages for each market segment in my portfolio? What’s “on sale” and what’s still over-priced?
Am still waiting for the “fat pitch” for many US stock segments. Like most hitters in baseball I don’t care why the fat pitch comes. The hard part is staying patient enough to avoid striking out.
One way to automate the ‘fat pitch’ part is with rebalance bands. Once my AA changes by more than 5%, I rebalance to my preferred AA. This forces me to sell what’s up, and buy what’s down. I am somewhat more aggressive on implementation with respect to stock declines, as my process effectively allows a smaller gap in that direction (long explanation omitted, I have two separate rebalancing triggers which in tandem drive the difference upside vs downside.) This helps me keep emotions out of my rebalancing decisions.)
Of course, ignoring rebalancing and letting it run for years works fine too. I am just the over-optimizing type, and need a system to keep me from fiddling my way to under-optimizing.