Second-Order Thinking: The Path To Better Investing Decisions
The process of thinking is often equated to a reflex. Just as our hearts beat without our direction, we shiver uncontrollably when our body temperature drops and our eyes blink 15–20 times per minute to lubricate our eyeballs and keep debris at bay, so too does our mind seem to operate on its own accord. We may not be aware of the specific neural pathways activated when we think, but we experience the thoughts as if they were happening to us. Welcome to the realm of first-order thinking.
First-order thinking is focused on the immediate situation. It is often characterized by quick, intuitive judgments and decisions. First-order thinking is necessary for making snap decisions in challenging conditions and routine decisions that don't require much thought. However, it can lead to poor decision-making without higher-order thinking.
Second-order thinking, on the other hand, is complex and requires significantly more effort. It entails the meticulous analysis and deliberation of multiple potential outcomes. Second-order thinking is not easy, but it is essential for making good decisions, especially when complex systems are involved.
Howard Marks is an investor known for his insights into the markets and ability to identify undervalued assets — but I find his insights into decision-making and behavior far more valuable. In his book "The Most Important Thing: Uncommon Sense for the Thoughtful Investor," Marks said:
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in "The outlook for the company is favorable, meaning the stock will go up.
Second-level thinking is deep, complex, and convoluted.
Another luminary who appreciates the significance of second-order thinking is Ray Dalio, the architect behind the world's largest hedge fund. Dalio warns against the perils of fixating solely on first-order consequences:
Failing to consider second- and third-order consequences is the cause of a lot of painfully bad decisions, and it is especially deadly when the first inferior option confirms your own biases. Never seize on the first available option, no matter how good it seems, before you've asked questions and explored.
Clearly, embracing second-order thinking is key to making wise investment decisions.
How do we think beyond the first order?
Examine multiple outcomes — Push beyond your initial conclusions and even your second. Stay open-minded and consider all possibilities, no matter how improbable they may seem. Sometimes, as we peel the layers back, outcomes that once appeared far-fetched become more plausible.
Keep asking, "What happens then." — The persistent asking of “What happens then?” is a potent tool in transcending the first order. When you reach a conclusion about a particular action, ask, "What happens next." And once you think you understand the consequences, ask again, "What happens then?" This iterative process is reminiscent of a curious child’s unwavering interrogation, but it's how children learn so quickly.
Consider the long-term effects — Second-order thinking considers non-immediate results. Many actions yield initial positive outcomes but carry long-lasting and damaging consequences. First-order thinkers often make decisions based on short-term perspectives, while those who think beyond the surface consider long-term effects. This approach proves especially valuable for investors who can extend their time horizon and patiently await the secondary and tertiary effects.
Benefits of Thinking Beyond the First Order
Phaedrus, the Roman fabulist, said:
“Things are not always what they seem; the first appearance deceives many; the intelligence of a few perceives what has been carefully hidden.”
Indeed, the few who transcend first-order thinking unlock a world of enhanced outcomes. If you want better results, begin practicing second-order thinking. Over time, deep thinking will become second nature, and you'll reap the rewards of your heightened cognitive efforts:
Better decisions —By refusing to settle for shallow thinking, you escape the predictable path followed by the masses. Embracing deeper, independent thinking will lead you to better decisions, setting you apart from the herd.
Better performance — by practicing deep thinking, you are likely already ahead of your peers. As mentioned earlier, second-order thinking is hard work. But as you base your decisions on second and third orders, over time, your choices will improve, and so too will the outcomes.
Fortunately, the frameworks that assist investors in achieving superior long-term results can be applied to various aspects of life. Thinking beyond the first order is a skill that transcends domains and empowers us to unlock the potential of our decisions.
