That's the title of Howard Marks' latest memo to clients, and one I highly recommend—especially given all the things that people worry about these days. One of the most important things that successful investors have to do is to 1) have a sense for what the market is assuming, and 2) decide whether the market is right or wrong in its assumptions. For most of the past seven years I've argued that the market was overly pessimistic about the future, and therefore it made sense to be long equities. As it turned out, the future didn't turn out to be as bad as the market thought, and prices rose impressively, despite some setbacks along the way. Here's just one of my posts that pointed out how pessimistic the market was, and how that presented an opportunity for investors whose own view of the future was not so pessimistic. When the world is worried about all the things that could go wrong (e.g., China, oil, the Middle East), then it makes sense to worry about what might go right.
Some excerpts from Howard's memo:
[Investing is] not supposed to be easy. Anyone who finds it easy is stupid.
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.”
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.” Second- level thinking says, “I think the company’s earnings will fall far 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 many things into account:
–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?