In the world of investing, the difference between success and mediocrity often boils down to how deeply one thinks about opportunities and risks. Howard Marks, co-founder of Oaktree Capital Management, is renowned for his deep insights into market behavior, and one of his most influential contributions to the field is the concept of “second-level thinking.” This idea, explored extensively in his memo “First Level Thinking vs. Second Level Thinking” and his book The Most Important Thing: Uncommon Sense for the Thoughtful Investor, offers a framework for investors seeking to transcend conventional wisdom and achieve superior results.

What is Second-Level Thinking?

At its core, second-level thinking is about going beyond the surface. Marks defines first-level thinking as simplistic, conventional, and reactive. It’s the kind of thinking that leads to conclusions like “This company is doing well; let’s buy its stock,” or “The economy is in trouble; sell your shares.” First-level thinkers tend to focus on the obvious and make decisions based on straightforward observations that are often already reflected in market prices.

Second-level thinking, on the other hand, is more complex, contrarian, and analytical. It requires asking deeper questions, such as:

• What is the consensus thinking, and why might it be wrong?
• If everyone believes the same thing, what are the implications?
• What are the second-order consequences of this event or decision?
• What might happen that others aren’t considering?

Marks summarises this by saying, “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.'”

This kind of thinking doesn’t just accept the obvious conclusion but instead digs deeper to uncover insights that aren’t immediately apparent. It’s about understanding the nuances of market behavior, investor psychology, and the hidden risks and opportunities that first-level thinkers often miss.

The Importance of Being Contrarian

Second-level thinking often requires investors to be contrarian in their thought process. Marks frequently points out that to achieve above-average results, one must be willing to think differently from the crowd. Markets are generally efficient, meaning that the consensus view is typically already reflected in prices. To outperform, an investor needs to identify situations where the consensus is wrong and act on that insight.

However, being contrarian doesn’t simply mean doing the opposite of everyone else. It’s not enough to be different; you must be different and right. Marks emphasises that successful second-level thinking requires both contrarianism and accuracy. This means having the insight to see things others don’t and the conviction to act on those insights even when they go against the grain.

Marks writes, “To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. That’s not easy.” Indeed, this is the essence of second-level thinking: seeing opportunities where others see none, and risks where others see only reward.

Examples of Second-Level Thinking in Practice

To illustrate second-level thinking, consider a scenario where a company reports strong earnings growth. First-level thinkers might rush to buy the stock, driving up the price. However, a second-level thinker might dig deeper and ask questions like:

• Is this growth sustainable, or is it driven by one-time factors?
• How much of the positive news is already priced into the stock?
• What are the risks that could derail this growth story?
• What happens if the broader market sentiment shifts?

By asking these questions, the second-level thinker might conclude that the stock is overvalued and decide to sell or avoid buying, even as others are piling in. This deeper analysis helps avoid overpaying for a company just because it has shown recent success.

Another example could involve a market downturn. While first-level thinkers might react to bad news by selling in a panic, a second-level thinker might look for opportunities that arise from the market’s overreaction. They might ask:

• Are certain sectors or companies being unfairly punished due to broader market fears?
• Could this downturn be an opportunity to buy quality assets at discounted prices?
• What are the long-term implications of this event, and how might the market’s perception change?

By thinking in this way, the second-level thinker is more likely to buy when others are fearful, capturing value that might not be immediately apparent.

Developing Second-Level Thinking

Marks’ work suggests that developing second-level thinking is less about intelligence and more about mindset. It requires a willingness to be skeptical of the obvious, to dig deeper into data and narratives, and to think independently of the crowd. It also demands patience and discipline, as the conclusions reached through second-level thinking often take time to be validated by the market.

Investors looking to cultivate second-level thinking can start by questioning everything. Instead of accepting a company’s success at face value, consider the reasons behind it, the sustainability of its business model, and the assumptions baked into its stock price. In times of market euphoria or panic, ask whether the market has become too optimistic or too pessimistic, and consider the potential for mean reversion.

Marks also stresses the importance of understanding the psychology of other investors. Since markets are driven as much by emotions as by fundamentals, second-level thinkers need to consider how sentiment might shift and what impact that could have on prices. Understanding behavioral finance and the common biases that affect decision-making can give second-level thinkers an edge.

The Tamim Takeaway

Howard Marks’ concept of second-level thinking is a powerful tool for investors seeking to outperform the market. By looking beyond the obvious, questioning consensus views, and thinking more deeply about the implications of events and decisions, investors can gain a significant edge.

Second-level thinking isn’t about being smarter than everyone else—it’s about thinking differently, more critically, and more independently. It’s about understanding that markets are complex and driven by a myriad of factors, many of which are psychological and behavioral. By cultivating second-level thinking, investors can navigate this complexity with greater confidence and clarity, positioning themselves for long-term success in the ever-unpredictable world of investing.

For those striving to elevate their investment game, the Tamim takeaway is clear: don’t settle for the obvious. Challenge assumptions, think deeper, and strive to see what others don’t. It’s in these often-overlooked spaces that the true opportunities—and the real rewards.