Grant's Review

Decisions about investing for retirement are complicated. Personal finance editor Andrea Coombes tells MarketWatch Radio's Adrienne Mitchell that a study shows those who get help do better than those who go it alone.

In Howard Marks’ book, The Most Important Thing, which has been praised by the likes of famous one-named investors such as Buffett and Bogle, he discusses the concept of “second-level thinking.”

 What is second-level thinking

Second-level thinking is essentially looking beyond the obvious. To quote Daft Punk, you need to think “harder, better, faster, stronger”, and take in many different angles and view points on a subject matter, in this case, stocks. For an example, Marks explains:

 “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.””

As it turns out, this second-level thinking actually requires a shift in the way we think. In a recent book by Nobel laureate Daniel Kahnman, covered in this week’s Businessweek, he describes two sides of the human mind through the use of two characters, System 1 and System 2.

“System 2 is your conscious, thinking mind… System 2 thinks slowly; it considers, evaluates, reasons. Its work requires mental effort –multiplying 24 by 17 or turning left at a busy intersection. We attribute most of our decisions to this thinking, reasonable fellow.

For Kahneman, however, the main protagonist is System 1. This is the agent of our automatic and effortless mental responses… The flaw in this remarkable machine is that it works with as little or as much information it has. If it can’t answer the question, “Is Ford stock a good investment?” it supplies an answer based on related but not really relevant data, such as whether you like Ford’s cars.”

Why This Matters

A few quotes I found interesting from November's Money magazine's interview with Harvard's David Laibson: 

"Laibson's [studies] have shown how hard-wired emotions can prevent investors from being the rational profit maximizers they need to be to invest wisely. One of the recent studies that Laibson was involved in used MRI brain images to prove that people are less emotional when it comes to making money-related decisions for others than when making moves that require their own immediate sacrifice."

I wonder how many individual investors continue to believe they can actively manage their own portfolio, or for that matter trade stocks, and consistently outperform the market or professional investors long-term. 

Not only are they up against some of the brightest people with huge teams at their disposal on Wall Street, they also have to somehow manage their emotions as well. Both of which, I am afraid, most people are acutely unaware of. 

"Think about the U.S. in the world economy. The U.S. accounts for about a quarter of the world's output, but most of us end up putting almost all of our net worth into assets that are closely tied to the fortunes of the domestic economy. For example, your house and your Social Security assets are tied to the U.S. economy. When you think about it that way, your only opportunity for foreign exposure is through your [investments]. If your [investments] are one-third of your assets and you put 75% of them into assets with foreign exposure, you still only have one-quarter of your total assets exposed internationally. Now, you can get some overseas exposure from shares of U.S. multi-nationals. But I would urge people to go beyond this. Investors need lots of international investments in their [investments] to obtain even a modest level of foreign exposure in their total portfolios.  

I can't imagine many investors use this second level thinking when analyzing the diversification of their portfolio. Let's say an investor reads some material on index funds and decides to purchase a few of them and call it quits thinking they have a diversified portfolio. Are they truly diversified? Have they considered that an S&P index fund only exposes them to large-cap U.S. stocks? What about the different asset classes such as mid and small-cap stocks? What about bonds, both national and foreign? What about foreign equities? What about commodities and real estate? Are you diversified tax wise, utilizing taxable, tax-free, and tax-deferred accounts?

Bull markets make investing look easy. While a basic index portfolio may do well in those times, what will happen when another bull market or recession occurs?