Second-level Thinking

May 6, 2023

Howard Marks, the founder of Oaktree Capital Management, makes the distinction between first-level thinking and second-level thinking.

First-level thinking is superficial analysis — investors (or any other decision makers) making decisions on market sentiment, recent news, or stock price. His examples:

  • “It’s a good company; let’s buy the stock”
  • “The outlook calls for low growth and rising inflation. Let’s dump our stocks.”
  • “I think the company’s earnings will fall; sell.”

On the other hand, second-level thinkers not only understand the market but the motivations and psychology of the market participants.

Marks notes some questions a second-level thinker might ask:

  • What is the range of likely future outcomes?
  • Which outcome do I think will occur?
  • What’s the probability I’m right?
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset comport with the consensus view of the future and with mine?
  • Is the consensus psychology that’s incorporated in the price too bullish or bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

Marks refers to the Keynesian Beauty Contest as an example of second-level thinking.

The whole thing in the Howard Marks 2015 memo, “It’s Not Easy.”