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By Samuel Lee

A version of this article was published in the November 2012 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Back in my college days when the market was booming, my father staked me $1,000 to invest on his behalf. He had read a biography of Warren Buffett and tasked me with the comically ambitious goal of "becoming like Warren Buffett." I didn't know much about investing then. I told him so. I said I'd do the research and get back to him.

A year later, I had devoured the seminal works of investing. The stock-picker's bible, The Intelligent Investor, and the canonical efficient-market tome, A Random Walk Down Wall Street, influenced me a lot. Reflecting the dueling philosophies I carried around in my head, I plunked down half of my money in index funds and, per my dad's request to become Buffett-like, 99 shares of Bank of America (NYSE:BAC) at $50.25 per share. (This was more than the $1,000 he had given me; the balance was mine, as I felt I had to put skin in the game. Buffett wasn't just an investing role model.) My reasoning was simple: Bank of America had a decades-long history of growing its dividend, had a simple, comprehensible business model, and looked cheap. A few months later, I was ecstatic when Buffett himself disclosed a new stake in Bank of America. I felt brilliant.

In hindsight, I was lucky on two counts. First, I bought something just before Buffett announced he had. Second, that something went down in flames, disabusing me of my stock-picking skills. In an alternate universe where Bank of America didn't buy Countrywide Financial, I might have gone on convinced that I was a brilliant stock-picker. Chances are, I would eventually have overbet and lost far more money than I did.

I can now look back and say my thought process was not deep enough for me to reasonably expect to earn above-average profits. My process was wrong. Even if my first pick had worked out, it would not be due to any genius of mine. My big error was I had failed to think about why other people would pass up this great opportunity. I was a level-one thinker. I was fortunate to have the market beat that fact into me early on.

The Perils of Level One
The most basic definition of level-one thinking I can think of is "reacting to new information in a typical way." That is, you think the same way as others. Level-one thinking isn't necessarily bad. If I brush my hand against a burning stove, I'll do the obvious thing and pull it away (and maybe curse). In many cases, the obvious thing to do is simply common sense, and common sense is useful. But markets are not the best place to apply this type of thinking. Markets aggregate the opinions of lots of smart people, so you can't gain an edge by seeing and doing the obvious (the exception being if the "obvious" to you is deeply aberrational to most investors).

The definition of level-one thinking can become quite punishing in the markets. Because many professional investors are aware of the folly of level-one thinking, they adjust their behavior to account for that fact. In doing so, the "obvious" market behavior now takes into account the fact that investors are looking at what some investors think other investors will do. Surpassing level-one thinking is now an exercise in figuring out how other investors are screwing up in their attempt to surpass level-one thinking. (This is another formulation of great economist John Maynard Keynes' "beauty contest.")

It is an annoyingly self-referential structure, but it's important to understand. A more refined definition of level-one thinking is "reacting to market information without adequately considering the behavior of other market participants." The investors who are not aware of level-one thinking and do not attempt to resist it are playing a game without even knowing the rules.

The Average Joe Rule
A good first step to moving beyond level one is looking at the ways average Joes differ most from not-so-average Joes. If average Joes do something that institutional investors can, but decline to do, chances are the average Joe is doing something silly (but this doesn't mean institutions are necessary smart--far from it).

One example is buying VIX-related "protection." The VIX is the "fear index," and what better way to hedge against market declines than to own fear itself? However, the VIX is not directly investable. Financial alchemists have created futures linked to it. A futures contract requires two sides: someone who is "long" and someone who is "short," so one person's gain is another's loss. Because individual investors can't gain access to VIX futures markets directly, they have to do it through ETFs and ETNs. The asset data show individual investors are, as a whole, overwhelmingly long VIX. By the zero-sum logic of derivatives, institutional investors must be short VIX. Guess how long VIX investments have done? iPath S&P 500 VIX ST Futures ETN (NYSEARCA:VXX) has lost over 99% of its value since its launch in January 2009.

Most professional investors operate by something like the average Joe rule. One measure they like to follow is the American Association of Individual Investors Sentiment Survey. If individual investors are bullish on stocks, that's a signal to be bearish, and vice versa. Unsurprisingly, professional investors apply the same logic to their peers. Bank of America Merrill Lynch's U.S. equity research team surveys the sentiment of "sell-side" strategists, analysts hired by investment banks and brokerages to make market prognostications.

Infinite Regress
You can go on like this forever. Taking polls of investors who take polls of investors who take polls. Where do you stop? One possible solution is to not play. Because you don't know which level is "right," just own market-cap-weighted funds and don't make any active bets.

Not a bad solution. In fact, I think this should be the default position, because it's clear many investors are stuck on level one and don't even know it.

I don't think it's the optimal way to play, though. This multilevel game where people try to anticipate what others are anticipating, and so on, surely has a solution. I suspect that for each level up we go, the number of people operating on that level shrinks by at least a factor of 10.

Here's where I think we should stop: exploiting patterns in which people willingly "sell" returns in exchange for some kind of "service." Let's take Warren Buffett. Anyone selling his company to Buffett knows he's being underpaid if the deal is looked at through a purely financial lens. So how does Buffett buy companies at a discount? He "sells" the assurance that the manager of a company will get to run it how he desires, and he sells the warm glow of being under the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) halo. In other cases, he rents out his reputation. During the financial crisis, he provided the imprimatur of safety to distressed but financially sound firms such as Goldman Sachs (NYSE:GS), Bank of America, and General Electric (NYSE:GE).

The presumption should be that someone smart is on the other side of your trade. Why would he willingly sell something for less than it is worth? If you can come up with a plausible answer and you have conviction in it, then you should make the trade. This is not to say outwitting the market is impossible or something you shouldn't try. But I think selling something for something else is a more reliable way of earning outperformance. It also grounds us into thinking about what's going through the other investor's mind when he is selling to us.

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Source: Levels Of Thinking