Lately I’ve been thinking about a good framework for my thought process on investing so I wrote down a short list of bullet points to get down to a few basic questions:

  • What is the consensus currently thinking?
    • What is the most important data point they are watching?
  • What are those with a contra (those few voices on the fringe) view saying?
    • What is the most important data point they are watching?
  • What outcome do I think will occur and why?
    • How does my expectation differ from the consensus?
    • What’s the probability I’m right?
    • What’s the risk/reward?
    • What is the range of likely future outcomes?
  • Asset Price
    • How does the current price of the asset compare 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?
  • Sentiment check:
    • Is it too bearish or too bullish?
    • Are we at an extreme?
  • Is this a good business going through a rough time or a bad business going through a good time?

I’ve based my thinking process on a memo written by Howard Marks from Oaktree who wrote the memo I Beg to Differ where he wrote this about second level thinking:

The basic idea behind second-level thinking is easily summarized: In order to outperform, your thinking has to be different and better.

Remember, your goal in investing isn’t to earn average returns; you want to do better than average.  Thus, your thinking 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 highly 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 have to be more right than others …which by definition means your thinking has to be different.

He wrote a great summary of how contrarianism works and actually feels at the extreme:

Markets swing dramatically, from bullish to bearish, and from overpriced to underpriced.

Their movements are driven by the actions of “the crowd,” “the herd,” and “most people.”  Bull markets occur because more people want to buy than sell, or the buyers are more highly motivated than the sellers.  The market rises as people switch from being sellers to being buyers, and as buyers become even more motivated and the sellers less so.  (If buyers didn’t predominate, the market wouldn’t be rising).

Market extremes represent inflection points.  These occur when bullishness or bearishness reaches a maximum.  Figuratively speaking, a top occurs when the last person who will become a buyer does so.  Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further, and the market is as high as it can go.  Buying or holding is dangerous.

Since there’s no one left to turn bullish, the market stops going up.  And if the next day one person switches from buyer to seller, it will start to go down

So at the extremes, which are created by what “most people” believe, most people are wrong.

Therefore, the key to investment success has to lie in doing the opposite: in diverging from the crowd.  Those who recognize the errors that others make can profit enormously from contrarianism.

As Marks says “to be an effective contrarian, you have to figure out:

  • What the herd is doing
  • Why it’s doing it
  • What’s wrong, if anything, with what it’s doing
  • What you should do about it

Good investment decisions made at the best opportunities – at the most overdone market extremes – invariably include an element of contrarian thinking.