Investing requires thinking one level up

On November 5, 2007, PetroChina's A-shares began trading on the Shanghai Stock Exchange at 48.62 yuan. People were lining up outside brokerage offices that day. The media called it "Asia's most profitable company," and buying its stock was presented as a way to share in the nation's energy lifeblood. A year later, the share price had fallen to 9.7 yuan. For most of the decade and a half that followed, it hovered between 7 and 10 yuan. Those who bought on the first day and never quite found the courage to sell eventually became famous as the punchline of investment jokes.

Around the same time, in January 2014, someone else bought Kweichow Moutai at around 118 yuan a share. The mood was almost the exact opposite of what it had been when PetroChina went public. The plasticizer scandal was still fresh, the government's Eight-Point Regulation had been introduced, group-purchasing channels had largely dried up, and a wave of distributors were selling off inventory at a loss. Moutai's price-to-earnings ratio had fallen to just over eight. Bearish views on liquor were the mainstream opinion, not a minority position. Brokerage research reports were full of phrases such as "channel collapse" and "prices inverted."

The difference between these two groups is usually explained in terms of who had the better eye for stocks. I don't think that's it. The real difference was that, at the moment they placed their orders, they were answering entirely different questions. Those buying PetroChina were asking, "Is this a good, big, profitable company?" Those buying Moutai were asking, "At this price, has the market already priced in the bad news likely to come over the next few years?" The second question operates at a higher level than the first. No matter how hard you work to answer the first, you cannot arrive at an answer to the second. This is what I mean by thinking one level up.

Let's start with time. The phrase "long-term investing" has been repeated so often that it has almost lost its meaning, and it is frequently misunderstood. The PetroChina investors held on for more than a decade, longer than most people who claim to be long-term investors. Holding for a long time did not improve their results. Time is on your side only if the underlying business is likely to improve over time, or at least not deteriorate. When that condition does not hold, time is not your friend but an accelerant. It accelerates decline just as readily as growth.

In 2014, Moutai's earnings were indeed falling, but several fundamental features of the business remained unchanged: customers paid before receiving their goods, the company did not need to commit large amounts of capital to expand, and it could raise prices without having to negotiate with distributors. The disruption in its distribution channels was cyclical; these characteristics were structural. Cycles pass. Structure endures. PetroChina was the opposite. It had no control over oil-price cycles, its exploration and refining operations consumed enormous amounts of capital expenditure every year, and the proportion of its earnings that ultimately reached minority shareholders in the secondary market had not changed. Hold it for ten years, and it would still be the same business. The sequence matters: first determine whether the business is likely to remain viable and profitable ten years from now; only then can time work in your favor. Reverse that sequence, and you are using time to gamble on something you have never properly understood.

The next level up is probability. Most people approach investing as if it were a series of true-or-false questions: Will the price rise or fall? Is this good or bad? Should I buy or not? Get the answer right and you make money; get it wrong and you lose. This approach feels intuitive, but it is highly inefficient. In the first half of 2015, many people around me predicted that a bull market was coming, and they were right. The Shanghai Composite Index rose from 2,000 to 5,178. There was nothing wrong with that call. But after June, several of those people had used margin financing at a 1:5 leverage ratio. During the successive limit-down sessions, they could not sell. By the time their accounts were forcibly liquidated, the index was still above 4,000. Their prediction was right. They were wiped out.

There is a reverse example, too. Someone began saying in early 2018 that Tencent was too expensive. That year, Tencent fell from HK$476 to HK$251, and the call was right. From 2019 to early 2021, however, it climbed all the way to HK$775, and the person was wrong for more than two consecutive years. In 2022, it fell to HK$198, and the call was right again. Over seven years, the calls alternated between right and wrong, roughly a fifty-fifty record by count. But suppose this person had invested a fixed amount every month throughout those seven years, never used leverage, and never liquidated the position during any downturn. The final result would have had far less to do with the accuracy of their predictions than most people imagine. Three other factors would have mattered far more: how much they wagered each time, whether they could survive being wrong, and whether they still had capital available when they were right. A casino never tries to predict whether your next hand will win or lose. It cares about only two things: the maximum bet and the number of hands played. Shifting your attention from "Am I right?" to "Is my way of betting positive or negative in expectation over the long run?" is the second step up in thinking.

The third level is structure. Changchun High-Tech provides a classic example. Before 2021, its human growth hormone business had delivered several consecutive years of strong growth. Institutional investors crowded into the stock, and brokerage research reports were overwhelmingly positive. After May 2021, news of centralized government procurement began to emerge, while doubts about eligible indications and market penetration also grew. The share price subsequently fell more than 70% from its peak. You could argue that investors had not researched the company deeply enough, but I see it differently. The company's revenue was heavily concentrated in a single product, and the pricing power for that product rested in the hands of policymakers. You could read the annual reports until you had memorized them and interview every distributor, yet you still would not know when a policy document would arrive or exactly what it would say. This is not a research problem. It is a structural problem, and structural problems can only be solved structurally. You can own the stock, but you cannot let it determine whether you survive as an investor. The same principle applies to heavily investing in a company whose revenue depends on a single major customer, or putting most of your money into the best stock in an entire sector. Neither is simply a question of whether you understand the business. Even when you understand it, the risk remains. Many people misunderstand portfolio construction as diversification into mediocrity. A portfolio is not designed to dilute returns. It is designed to ensure that no single mistaken judgment can force you out of the game. Being able to stay at the table after getting something wrong matters far more than getting this particular decision right.

The fourth level is to ask yourself a particularly simple question: If I make money on this investment, who, exactly, is paying me? There are only four possibilities: the company pays me dividends; the company's profits grow, increasing my share of those profits; the market becomes willing to pay a higher price for the same amount of profit; or the next person is willing to buy the shares from me at a higher price. The first three ways of making money involve earning alongside the business. The fourth involves making money out of someone else's pocket. The difficulty differs by an order of magnitude.

LeEco's stock reached a high of 179 yuan in 2015. The people buying it were not necessarily blind to the fact that the company was unprofitable. Many knew perfectly well what was going on. They were betting on the fourth possibility: that someone else would take the baton from them. In 2020, the stock was delisted, and during the delisting period it fell as low as 0.18 yuan. Tencent was a different case. From 2018 to 2021, its profits generally kept growing, yet its share price first fell from HK$476 to HK$251, then climbed to HK$775, before dropping back to HK$198. Most of the fluctuations in between were not driven by changes in profit, but by changes in the valuation multiple the market was willing to assign. If you think you are making money from the second source when you are actually making it from the third, you have no idea when you should get out. In recent years, people have started buying PetroChina again, but the rationale has changed. They are no longer buying for growth, but for dividend yield. The same company can generate returns in entirely different ways. Understanding that is far more useful than arguing over whether it is a good company.

The final level is one that almost nobody accounts for: yourself. In 2015, brokerage research analysts heavily invested in brokerage stocks. On the surface, their reasoning was, "I understand this industry better than anyone." In reality, they had tied both their salaries and their investment portfolios to the same variable. In the second half of that year, industry bonuses were cut, and the stocks were also halved in value. The situation was even more extreme in 2021. People working in the private education sector held shares in New Oriental and TAL Education. When the government's "double reduction" policy was announced in July, Chinese education stocks listed in the United States lost 70% to 90% of their value in a single month. Many people lost both their jobs and their investment portfolios. Your salary is one source of beta; your portfolio is another. They should not depend on the same underlying factor. A real estate employee borrowing heavily to buy a third property, or a bank employee putting all their money into bank stocks, is making the same fundamental mistake.

There is another level beneath that: when will you need the money you are investing? Money needed for a down payment within three years and money that will not be touched for twenty years are fundamentally different, yet people often invest both according to the same logic. Many investors do not lose money primarily because they chose the wrong asset. They lose because they need the money at the worst point in the market and are forced to sell at the bottom. That is why the first line of a truly complete portfolio sheet should not be a stock ticker, but information about you: what you do for a living, how stable your income is, how much debt you owe, and what major expenses you expect over the next three years. These factors determine how much risk you can bear. The market does not care how much you can bear.

You do not need to memorize all these levels. In practice, there are really only three things worth doing. First, before placing an order, write down three lines: how long you intend to hold the investment, where your returns will come from, and the maximum you could lose if you are wrong. If you cannot write down any one of them, do not buy yet. This may seem simplistic, but it can prevent more than half of impulsive trades. Second, shift your attention from "Has the price gone up?" to "How much have I wagered?" Your judgments will always sometimes be right and sometimes wrong, but your position size is the one thing you can fully control. The same investment thesis means two entirely different things when you allocate 10% of your portfolio versus when you invest everything with leverage. Third, once a year, put your income, debts, future expenses, and investment holdings on the same sheet and review them together. Most people have never done this. Once they do, they discover that they are far less diversified than they imagined.

Thinking one level up does not guarantee that you will make money this time. What it does is keep one mistaken judgment from driving you out of the market permanently. Those who survive in the market for a long time have never done so simply by making more accurate predictions. They survive because, when they do not fully understand what is happening, their losses are still limited.

This article reflects my personal thoughts. The companies mentioned are used solely to illustrate the points discussed and do not constitute investment advice. All investment decisions carry risk, and you are responsible for your own decisions.