Learn the stock market in 7 easy steps. Get spreadsheets & eBook with your free subscription!

Second-Order Thinking: A Critical Component of Smart Investing

“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.”

Ray Dalio

Your ability to think through any problems to the next level, i.e., second, third, fourth, etc., or what is referred to as second-order thinking is an incredibly powerful tool that will supercharge your thinking.

Investing is an incredibly difficult game to play, as there are so many different variables, and the ability to think beyond the first-order such as I like this company will go a long way towards your long-term success as an investor.

In today’s post, we will cover:

  • What is Second-Order Thinking?
  • How to Solve Problems Using Second-Order Thinking
  • Improving Your Ability to Think
  • Ray Dalio and Second-Order Thinking

Ok, let’s dive in and learn how second-order thinking can improve our decisions.

What is Second-Order Thinking?

In the remarkable book, The Most Important Thing, Howard Marks first brought to my attention the concept of second-order thinking, which he refers to as second-level thinking.

“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.”

First-order thinking is quick and easy, not a lot of effort is required to conclude. It happens when we are looking for an answer that solves the problem immediately without thinking through the consequences. For example, I am thirsty, so I must get a beer to quench my thirst.

Second-ordering thinking is far more deliberate. It is thinking in terms of action and time, understanding that our actions can cause harm, despite our best intentions. A question all second-order thinkers ask is, “and then what?” For example, thinking about drinking beer every time you are thirsty and what are the consequences of drinking that much beer, and using that information to inform your decision. Likely you are to rethink that decision and choose a healthier beverage.

First-level thinking is natural and looks similar to everyone’s decisions, as everyone reaches the same conclusions. If you are thirsty, you will drink something to quench your thirst.

The challenge to out-think others comes not from first-order thinking but utilizing second-order thinking. Extraordinary results come from seeing what others are unable to see.

I can guarantee you that Warren Buffett and Charlie Munger employ this type of thinking when considering any decision they make. The same would apply to Mohnish Pabrai, Howard Marks, Ray Dalio, and the list goes on and on.

The Difference Between First-Order and Second-Order Thinking

First and second-order thinking is different from Daniel Kahneman’s concept of System One and System Thinking form his seminal book, Thinking Fast and Slow. In his book, Kahneman contrasts thought processes and purposeful, logical thought processes.

Howard Marks’ focus is making smart investment decisions, and he spends quite a bit of time thinking through the possibilities of all investments before he pulls the trigger. If you ever read his notes to investors that will spring out to you.

First-order thinking focuses on solving the problem immediately in front of you, with little or no thought involved in the consequences. In Mark’s words, “first-level thinking is superficial and simplistic, and just about everyone can do it.”

First-order thinking sounds foolish and rather simple, but our minds are programmed to seek the most straightforward, quickest solution to a problem. Many of us find it difficult to think beyond our first conclusion. And if the time is compressed for a decision, the likelihood of a first-order choice rising exponentially. Add to that fact; we are not experienced in our role, are experiencing strong emotions, or don’t have options for other points of view.

Add the fact that our thinking is affected by our biases and heuristic methods of problem-solving.

Some examples of Mark’s thoughts on second-order thinking:

  • Investors who use first-level thinking see what they think is a good company and decide to buy. Those who use second-level thinking see the crowd is enthusiastic about the “good” company and, therefore, believe it is overpriced and proceed to sell.
  • First-level thinkers see low growth and rising inflation, leading them to sell. But second-level thinkers see everyone selling in panic and decide to buy.
  • First-level thinkers believe a company’s earnings will fall, and they sell their shares. Again, second-level thinkers have a different perspective; they think the earnings will fall less than expected, so they buy.”

The above are all great examples of decisions that second-order thinkers might take and are ideas to think through. Wall Street tends to have a herd mentality, and when things are lousy, everyone runs for the streets, but second-order thinkers consider the circumstances and come to a different conclusion.

A great quote I came across yesterday illustrates this point perfectly:

“You make most of your money in a bear market; you just don’t realize it at the time.”

Shelby Davis

But fear not, second-order thinking is a skill we can all develop, with a little effort.

Ray Dalio on Second-Order Thinking

Here is an excerpt from the fantastic Principles by Ray Dalio.

By recognizing the higher-level consequences nature optimizes for, I’ve come to see that people who overweigh the first-order consequences of their decisions and ignore the effects of second- and subsequent-order consequences rarely reach their goals. This is because first-order consequences often have opposite desirabilities from second-order consequences, resulting in big mistakes in decision making.

For example, the first-order consequences of exercise (pain and time spent) are commonly considered undesirable, while the second-order consequences (better health and more attractive appearance) are desirable. Similarly, food that tastes good is often bad for you and vice versa.

Quite often the first-order consequences are the temptations that cost us what we really want, and sometimes they are the barriers that stand in our way. It’s almost as though nature sorts us by throwing us trick choices that have both types of consequences and penalizing those who make their decisions on the basis of the first-order consequences alone.

By contrast, people who choose what they really want, and avoid the temptations and get over the pains that drive them away from what they really want, are much more likely to have successful lives.”

Think about learning investing; it is hard a first because of the jargon, math, fear of failure. But the result is what we want, but the pain of getting there is sometimes too complicated, and we strive for quick answers.

Instead of reading, learning from other investors you trust, and studying the ideas of great investors, many of us turn to the quick fix. Find a website that tells you that these are the ten must-buys of 2020, for example. Investing is a compounding game; the more you learn, the better your decisions you will make, and the more you will learn. And it grows from there.

The way that Warren Buffett invests now is different from the way he invested when he was young. When he began, he bought cheap companies with low PE ratios and waited for the prices to rise before selling them and moving on to the next opportunity. Once he met Charlie Munger, he changed his philosophy and started buying higher quality companies at better valuations, which increased his performance.

Investing is a long-term game, not a one-time event. Chasing short-term success leads to long-term agony. Think about a CEO that chases earnings gains by manipulating the stock price so he can gain from stock options and then selling those shares when the price is inflated. But in the long run, it harms the business because the value is eroding by the constant manipulation, and this ultimately hurts the shareholders, the real owners of the company.

If you have not read Ray’s book, I highly recommend it. The text is full of great wisdom, and he shares his personal history mixed in with insights, which helps illustrate his ideas. Plus, he shows how he has made mistakes in his life and how he has tried to learn from those mistakes.

Let’s move on and learn how to become a better thinker.

How do You Develop Second-Order Thinking?

Second-order thinking is a deliberate and proactive process and will take some time and practice to develop, so have a little patience with yourself.

  1. Question Everything

Ask the “And What If” question and don’t stop at the first answer or solution, or even the second or third. Keep questioning yourself and your thoughts until you have a clear roadmap of possibilities.

For example, if you find a company with growing earnings. Don’t just stop with that; look at why the earnings are growing. Is revenue growing? Are the expenses dropping? Did they have a higher or lower tax rate that year, or are they buying back shares, which is lowering their share count, which correspondingly raises the earnings. If you find the revenue is flat, then investigating how the earnings are rising would merit some investigation because you have to ask yourself how long that can continue.

At this stage of developing second-order thinking, it is essential to approach your ideas with curiosity to explore the subject in depth. Not to the point of it becoming disruptive, over-analysis, or even doubt your decisions to the point of making no decisions at all.

  • Involve Others

Sometimes we get caught in first-order thinking because we aren’t aware of what other possibilities are available. But when we involve others in our decision-making process, they bring outside views and new perspectives.

Having another person to reach out to ask questions and have critique your ideas is an essential way to involve second-order thinking.

Think Warren Buffett and Charlie Munger.

I am fortunate that I have Andrew as a person that I trust and know will be honest in his perspectives and comes from a different place than I do, and that can be a valuable asset when making investment decisions.

  • Think in the long-term

The power of second-order thinking comes from being able to look past the immediate results and see the impact long-term. Sometimes a short-term pain may result in a long-term gain.

As value investors, it is in our nature to look long-term at our investments. We look for companies that are under some sort of duress, whether it be temporary pain from a short-term event, or the company is in a sector that is particularly hated at the moment. Warren and Charlie bought Wells Fargo when it was $3 a share during the financial crisis in 2008, or Coca-cola in 1988 when it was $8 a share.

One way to practice these skills is to think about your decision, and what will the results in one day? One week? One month, or a year? Five years, or ten years?

It is important to remember that the conditions might not be similar to the longer out you look.

  • Don’t discount other options too quickly

Keep all of your options on the table at first. You never know, your first impression might be the best one. When thinking through any problem, try to remember all possibilities and think through all of them to their fullest point.

  • Use systems and psychology

Charlie Munger is the master of using systems to help his decision making. His latticework of mental models is the framework for which he uses to make any decision he is considering.

Using these types of systems will help you overcome your biases, which are our brains way of making decisions. We all have thousands of biases that help us function; the world is full of too many stimuli just to interpret what we see, hear, or touch, so our brain develops these biases to help us get through the day.

The building blocks of our systems is the latticework, which comprises much of what we have learned in our life. Building upon those latticeworks helps improve our decision making.

Some familiar latticeworks are:

  • Accounting
  • Biology
  • Chemistry
  • Physics
  • Finance
  • History
  • Psychology

Take psychology; for example, marketing and advertising firms use psychology to get us to buy things. The more they can figure out how people think, the more they can use that to their advantage to encourage people to buy the things they are advertising.

For more on this critical step I would encourage you to listen to a speech that Charlie Munger gave to Harvard University in 1995, it is fantastic, and it illustrates all the points Charlie tries to make about psychology.

Other resources would be Shane Parrish’s fantastic blog Farnam Street and any of Charlie Munger’s speeches and writings.

This all sounds amazing, but how do we get better at all of these ideas?

Simple, practice, practice, and more practice.

Final Thoughts

Ok, we have established how vital second-order thinking is and difficult. In fact, Charlie Munger once said:

“Its not supposed to be easy. Anyone who finds it easy is stupid.”

A lot of extraordinary things can come from a first-order negative and second-order positive like your health. The first-order negative would be the pain from exercising and diet, but the second-order positive would be the improved health.

Just because things don’t have an immediate payoff, like investing in a company that is down in price, doesn’t mean that in the long run, it won’t become a fantastic compounder for you.

What a lot of this means is that as a second-order thinker or beyond, you will encounter less competition as most will focus on the first-order results, and won’t work things through to the conclusion.

Second-order thinking requires a lot of work, and it is not easy to think in different systems, times, and patterns. But, it is the smart way to separate yourself from the masses and achieve what you want to achieve.

Ok, that is going to wrap up our discussion on second-order thinking. I hope you find something of value on your investing journey.

As always, thank you for taking the time to read this post, and if you have any questions, please don’t hesitate to reach out.

Until next time.

Take care and be safe,

Dave