Investors need second-level thinking

By DAVID MOON, Moon Capital Management, LLC
February 19, 2012

In a small Polish town on this date in 1473, a future seminal world thinker was born. Nicolaus Copernicus was a mathematician, astronomer and lawyer. He studied medicine and theology. He is, of course, best known for his 1543 book, “On the Revolutions of the Celestial Spheres,” in which he turned the world upside down (literally) by suggesting that the Sun was the center of our universe.

I’m sure there are some practical benefits to Copernicus being right and Aristotle and Pope Urban VIII being wrong about heliocentricity versus egocentricity, but until I can afford to fly in a space ship, I don’t think it means much to me.

Copernicus did, however, set an example about a way of thinking that is useful in most ventures, including investing. Copernicus was able to reach a conclusion by observing a number of things he could not see. Anyone with two feet knew that the earth stood still, and anyone with two eyes knew that stars and planets moved across they sky.

That very simplistic analysis was convenient, but it didn’t explain the actual paths the planets traveled across the sky.

The full explanation of the paths and the relationships between the bodies in our solar system required being able to see the obvious (the visible position of planets) and the effects of the not-so-obvious (gravity.) Even with powerful telescopes, scientists still sometimes identify the existence of something unseen simply by the movement of something that is seen.

That is Copernicus’ genius.

Investor Howard Marks calls it second-level thinking.

Most investors never get beyond first-level thinking. They focus on the obvious, drawing the obvious, simple and often too late, conclusions.

In July 2011 Standard and Poor’s placed the credit of the United States federal government on its watch list, in anticipation of a possible downgrade from AAA, the highest level. Investors and analysts feared that a downgrade would cause a collapse in US bond prices and a general financial apocalypse.

That is first-level thinking. The US hasn’t deserved a AAA-type rating for years. Changing the label was only a formality.

Since Standard and Poor’s officially downgraded the US debt on August 4, 2011, the 30-year Treasury bond has increased 8 percent in price. The Dow Jones Industrial Average has increased 13 percent.

So much for Armageddon.

Second-level thinkers look for the impact of the non-obvious.

Greece is bankrupt. That is obvious. They cannot pay what they have promised to pay. JP Morgan knows that. Tim Geithner, Angela Merkel and Lucas Papademos all know that. Unless you just want something to talk about, quit asking yourself what happens if Greece goes under. It already has. That’s a first-level question.

Every airplane I get on these days is packed. First-level thinking would suggest buying airline stocks – an industry that has, in total, lost money since its inception.

If something is so obvious that it has already appeared in USA Today, it’s probably already reflected in the price of the investment.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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