As a young adult growing into adulthood, one thing that I’ve been increasingly curious about is investing. There’s so many options but I have no knowledge or expertise on the correct action to take. Luckily I have a friend that could point me to some basic resources. The first of which was “The Most Important Thing” by Howard Marks. What I enjoyed about it was its emphasis on the philosophy of defensive investing. Just like running a startup, risk is the most challenging part and must be managed accordingly.
Second Level Thinking
First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.
The market is me by definition. So why do I think that I can do better than me and the people better than me? Some are going to have superior analysis, advanced models and years of education in a space that I’m not very familiar with. Introducing what Marks calls “second level thinking”.
- 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!”
Asking second level questions can be hard and takes a lot of practice + experience to learn from. However, one context to easily apply this style of thinking is through market cycles.
Bears and Bulls
Risk of an asset should be baked in and considered into the price of it. When things start going well, the perception of risk is reduced and its consideration in its price is slowly eliminated. To bring it back to the first point about second-level thinking I’m going to reference the 2017 ICO craze.
Everyone thought that they too could relive the experience of holding a digital asset that goes from $1 to $10,000 overnight with a global pool of liquidity. Many, including myself, used first-level thinking such as:
- This technology is new and revolutionary. Everyone’s making money on it, so surely it must be safe. If it’s safe then I should invest and make large sums of money too.
However, very few stopped to ask themselves the following and not participate in the hype:
- If everyone is basing the value of this technology in the future, what risks might it entail? Are the risks of this asset/project baked into the price? If not, why should I buy it?
- Everyone seems to be making money on it. Successful investing requires having a contrarian view aka knowing information which the market itself doesn’t know about.
In hindsight these are very easy questions to ask, but very few were able to use level headed reasoning. Everyone from retail investors to VCs in private sales got caught out. This goes to show the power of market psychology. I respect Ari Paul in his blog for being hyper aware of this:
“Over the following month, the ICO table got much more competitive. Initial valuations skyrocketed as investor capital flooded into the space. And a great many of the professionals entering cryptocurrency are currently focused on ICOs. So…for now at least, I’m not.”
So what should the optimal strategy for investing be? Well it depends since investing is a zero-sum game.
As an individual, limiting yourself to how much you can afford to lose is the most important thing. However given the choice, how many would cap their gains in a bull market? It’s very hard to say since greed takes over. As result, what was green becomes red to the point that you can’t tolerate.
Here’s a list of what a bull herd psychology looks like and what bear psychology looks like.
Knowing yourself and the environment in the present is a key lesson I learned from this book. Predicting the future is a game of luck, not skill. The chance you get it right can lead to massive pay offs, although incorrectly guessing could lead you to lose everything depending on how you managed your risk. I’m still a beginner when it comes to investing although I hope to share more about my learnings as I go along this journey with you all!