When you invest – you can’t simply do what the crowd does and expect to outperform the market.

No – to beat the market (performing better than the average), it takes diligence, foresight, imagination, risk, and most of all – some luck.

But – putting it simply – you must start thinking two moves ahead of your competition (the crowd) . . .

One of my favorite contrarian investors – Howard Marks – calls this ‘second level thinking’.

Basically – it means to think past what the crowd’s expecting today. And instead, think about what they’ll be expecting in the future.

For example – if news broke that there’s an expected over-supply of oil – crude prices will sink.

That’s how ‘first-level thinkers’ operate – they price new information in immediately.

But a second-level thinker looks past the expected short-run. And into the longer-run.

For instance – in this case – they would notice three things. . .

First – marginal (aka on the edge) oil producers can’t keep producing at much lower prices.  Thus the declining oil production will rid the over-supply problem.

Second – since everyone’s expecting falling oil prices, they’re selling and even shorting oil stocks. But we know that when someone shorts stocks – they’re simply borrowing shares to do so. And eventually, they’ll have to buy those same oil shares back to ‘close out’ the short position (i.e. return to borrower). This additional buying from short positions closing out will push prices higher later.

And Third – one report indicating an over-supply of oil could be exaggerated. Or flat out wrong. Maybe increased global demand will absorb more oil than expected. For example – news could break next week that a foreign country took advantage of the lower oil price and bought much more crude than expected – rendering the over-supply of oil gone.

All these reasons are why the second-level thinker will look to take advantage of cheaper prices – because of the crowd’s simplistic and superficial views – and go long oil (or at least prepare to).

Here’s another way to think about second-level thinking. . .

Imagine you’re walking down a busy sidewalk in Manhattan during winter. And next to you is a friend.

“What are the chances there’s a $100 bill just laying here that someone dropped,” you say..

“That’s not possible. Because if there was, someone else would have picked it up by now,” he replies.

You think to yourself: that’s true – I suppose. If there was money on the floor, someone would have snatched it up by now.

But imagine if everyone thought this way. . .

Suddenly – you spot the opportunity.

If everyone already expects that any money would have been picked up already. Then no one would ever even bother looking down at the sidewalk floor because they wouldn’t expect to find anything.

So now you decide to start ignoring everyone’s assumptions – and start looking for yourself.

And the next thing you know – there’s tons of money on the floor being walked all over. And all yours to take since no one else is even bothering to look.

This is exactly what’s going on in markets.

The crowd (and modern portfolio theorists) believe that markets are so efficient that it’s not possible to find huge opportunities. Because if they existed, they would have been priced in already.

But like I’ve written before; markets are efficient – but only 90-95% of the time.

And it’s the job of ‘second-level thinkers’ to find these opportunities – and exploit them.

So – in summary – there’s two key takeaways from all this to store in your ‘mental toolbox’. . .

First – since markets are widely expected to be efficient, many don’t bother looking for inefficiencies (aka huge opportunities to beat the market). Thus this gives the ‘second-level thinker’ the opportunity to do so.

And Second – to beat the market, you must think two-steps ahead of the crowd (your competition).