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hey this is Chris Franco and you are listening to compound money quiet Le the cmq investing podcast cmq investors welcome to the show it's great to have you here in this episode you will learn about the way that you have to think if you have any chance of beating the market it's a concept called second level thinking and I'll be reading from one of my favorite investing books of all time it's called the most important thing illuminated it's written by Howard Marx and it made a big impression on me when I first read it several years ago and it still has an effect on me today and make sure to listen till the end because I will share my key takeaways after we finish reading from this book let's get to it few people have what it takes to be great investors some can be taught but not everyone and those who can be taught can't be taught everything valid approaches work some of the time but not all and investing can't be reduced to an algorithm and turned over to a computer even the best investors don't get it right every time the reasons are simple no rule always works the environment isn't controllable and circumstances rarely repeat exactly psychology plays a major role in markets and because it's highly variable cause and effect relationships aren't reliable an investment approach may work for a while but eventually the actions it calls for will change the environment meaning a new approach is needed and if others emulate an approach that will blunt its Effectiveness investing like economics is more art than science and that means it can get a little messy because investing is at least as much art as it is science it's never my goal in this book or elsewhere to suggest it can be routinized in fact one of the things I most want to emphasize is how essential it is that one's investment approach be intuitive and adaptive rather than be fixed and mechanistic at bottom it's a matter of what you're trying to accomplish anyone can achieve average investment performance just invest in an index fund that buys a little of everything that will give you what is known as market returns merely matching whatever the market does but successful investors want more they want to beat the market in my view that's the definition of successful investing doing better than the market and other investors to accomplish that you need either good luck or Superior Insight counting on luck isn't much of a plan so you better concentrate on Insight in basketball they say you can't coach height meaning all the coaching in the world won't make a player taller it's almost as hard to teach insight as with any other art form some people just understand investing better than others they have or manage to acquire the necessary trace of wisdom that Ben Graham so eloquently calls for for everyone wants to make money all of Economics is based on belief and the universality of the profit motive so is capitalism the profit motive makes people work harder and risk their Capital the pursuit of profit has produced much of the material progress the world has enjoyed but the universality also makes beating the market a difficult task millions of people are competing for each available dollar of investment gain who will get it the person who's a step ahead in some Pursuits getting to the front of the pack means more schooling more time in the gym or Library better nutrition more perspiration greater stamina or better equipment but in investing where these things count for Less it calls for more perceptive thinking at what I call the second level wbe investors can take courses in Finance and Accounting read widely and if they are fortunate receive mentoring from someone with a deep understanding of the investment process but only few of them will achieve the superior Insight intuition sense of value and awareness of psychology that are required for consistently above average results doing so requires second level thinking remember your goal in investing isn't to earn average returns you want to do better than average thus your thicking has to be better than that of others both more powerful and at a higher level since other investors may be smart well informed and high computerized you must find an edge they don't have you must think of something they haven't thought of see things they miss or bring Insight they don't possess you have to react differently and behave differently in short being right may be a necessary condition for investment success but it won't be sufficient you must be more right than others which by definition means your thinking has to be different what is second level thinking first level thinking says it's a good company let's buy the stock buy it baby this one's hot 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 first level thinking says the Outlook calls for low growth and Rising inflation let's dump our stocks second level thinking says the Outlook stinks but everyone else is selling in panic buy first level thinking says I think the company's earnings will fall sell trust me my intuition is never wrong second level thinking says I think the company's earnings will fall Less Than People expect and the pleasant surprise will lift the stock buy first level thinking is simplistic and superficial and just about everyone can do it a bad sign for anything involving an attempt at superiority all the first level thinker needs is an opinion about the future as in the outlook for the company is favorable meaning the stock will go up second level thinking is deep complex and convoluted the second level thinker takes a great many things into account for example 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 of the asset comport with a consensus view of the future and with is the consensus psychology that's Incorporated in the price to bullish or bearish and finally what will happen to the assets price if the consensus turns out to be right and what if I'm right the difference in workload between first level and second level thinking is clearly massive and the number of people capable of the latter is Tiny compared to the number capable of the formor first level thinkers look for simple formulas and easy answers second level thinkers know that success in investing is the antithesis of simple that's not to say you won't run into plenty of people who try their darnest to make it sound simple some of them I might characterize as mercenaries brokerage firms want you to think everyone's capable of investing at $10 per trade mutual fund companies don't want you to think you can do it they want you to think that they can do it in that case you'll put your money into actively manage funds and pay the associated High fees others who simplify are what I think of as the prizers some are academics who teach investing others are well-intentioned practitioners who overestimate the extent to which they're in control I think most of them fail to tote up their records or they Overlook their bad years or attribute losses to bad luck finally there are those who simply fail to understand the complexity of the subject a guest commentator on my DriveTime radio station says and I quote if you have had good experience with a product by the stock end quote write that down buddy that's genius there's so much more than that to being a successful investor first level thinkers think the same way other first level thinkers do about the same things and they generally reach the same conclusions by definition this can't be the route to Superior results all investors can't beat the market since collectively they are the market before trying to compete in the zero some world of investing you must ask yourself whether you have a good reason to expect to be in the top half to outperform the average investor you have to be able to outthink the consensus are you capable of doing so and what makes you think so the problem is that extraordinary performance comes only from correct non-consensus forecasts but non-consensus forecasts are hard to make hard to make correctly and hard to act on you can't do the same things others do and expect to outperform unconventionality shouldn't be a goal in itself but rather a way of thinking in order to distinguish yourself from others it helps to have ideas that are different and to process those ideas differently the upshot is simple to achieve Superior investment results you have to hold non-consensus views regarding value and they have to be accurate that's not easy for your performance to diverge from the norm your expectations and thus your portfolio have to diverge from the norm and you have to be more right than the consensus different and better that's a pretty good description of second level thinking those who consider the investment process simple generally aren't aware of the need for or even the existence of second level thinking thus many people are misled into believing that everyone can be a successful investor not everyone can but the good news is that the prevalence of first level thinkers increases the returns available to second level thinkers to consistently achieve Superior investment returns you must be one of them okay it's funny I said I was going to have my key takeaways but really what Howard Marx just wrote is perfectly said I mean what I want to do is look at a few of the key points and just elaborate so I have some notes in front of me the first and this is the probably the biggest idea that we all need to remember and it's it's important because as we've mentioned before overconfidence is a killer for us as investors that's what causes us to make mistakes and those mistakes interrupt the compounding process what I'm getting to is that to consistently achieve Superior investment returns it's extremely hard and what I like about that chapter is it really lays out just the reality of what any investor who chooses to go and attempt to you know beat the average rate of return that's what you're up against and I think sometimes when we break down the Warren Buffett Charlie Munger methodology and you know it's great because it we can describe it in simple terms but many investors are likely looking at it in a overly simplistic way I know when I was earlier in my inv investment journey I definitely did I thought I just had to you know find a company I knew something about and just load up because that's what you do what I didn't factor in was the psychology and I've discussed that in some of our Instagram lives and it just reminded me of another Charlie Munger quote which is mimicking the herd invites regression to the mean or merely average performance in order to be a second level thinker you have to go against the consensus and the consensus by definition is the majority so the majority can't all do exceptionally well the majority is not going to aeve achieve Superior returns that's only going to be reserved for a small percentage of the participants so I just love the logic here if you start seeing everyone saying something is a sure thing well in all likelihood they're wrong they're first level thinkers and I was getting at that without saying second level thinking but I was discussing that in our episode which I believe it was just one episode ago about is Bitcoin the greatest investment opportunity of a lifetime I'll let you go back and listen to that rather than turn this into another Bitcoin rant but uh you know it's it's the same idea like it's just the the logic of it Superior returns are only reserved for Superior performers and Superior performers are not going to be the majority they're going to be a small percentage I think I've heard Charlie Munger say that only one out of five can be in the top 20% it's a little bit of a tongue-and-cheek expression but it really says what we're trying to say here if you're going to be doing better than the consensus that well then you're going to have to think differently than the consensus but not just like Oh I'm a contrarian I I think differently I'm an independent thinker no you have to be you have to diverge from the the consensus and you have to also be right and that's what I love when Howard marks makes the point of saying second level thinking is different and better it's not just different it's different and better hey guess who's back it's me Conor the overconfident investor what's up with that Howard Hughes guy making investing sound so tough stocks go up you buy the dip you get the Doge then you pick out your Lambo I'm so rich you know to be honest I thought I'd never walk again when I bought my segue last week this thing's awesome this has been compound money quiet lead the cmq investing podcast my name is Chris Franco thank you for listening we'll talk soon
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