Second-Order Thinking | The Latticework

Analogy

Second-Order Thinking is like playing billiards.

Amateurs only play one move ahead – only thinking about which ball they want to sink next. However, professionals not only think about their next shot but also where they want the cue ball to end up so that they set themselves up for an easy shot afterward.

If you can think, see, and play several steps ahead – employing second-order thinking – you too can become a “professional” – setting yourself up for “easy shots” too.

Diagram

We can harness second-order thinking through a decision tree methodology. Decision trees are a technique for visualizing probabilities and payoffs, allowing for the evaluation of various choices. The goal is to go down the path of least risk and greatest reward. To start, assign a value and likelihood for each outcome, with the percentages adding up to 100%. Multiply the likelihood by the value in order to produce the expected value. It may sound simple, and it is, but the outcome gives you a clear visual representation of the attractiveness of your options. This process is an easy and effective way to begin practicing second-order thinking, forcing us to think through various criteria. It is the process itself that is helpful, not necessarily that it is perfectly precise. Remember, accuracy > precision.

One of the advantages of a fellow like Buffett is that he automatically thinks in terms of decision trees.

– Charlie Munger

Example

Howard Marks says it best in his superb book, The Most Important Thing.

First-level thinking says, “it’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So, the stock’s overrated and overpriced; let’s sell.”

First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in a panic. Buy!”

The difference in workload between first-level and second-level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former.

First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.

First-level thinking is simplistic and superficial and just about everyone can do it. Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account:

What is the range of likely future outcomes?

Which outcome do I think will occur?

What’s the probability I’m right?

What does the consensus think?

How does my expectation differ from the consensus?

In another beautiful example, when Britain occupied India, the British were concerned with the quantity of venomous snakes. To try to combat this, they promised a monetary reward for every dead snake brought back (Incentives). You would think that this helped reduce the number of snakes, right? Dead wrong. Locals began breeding snakes to make more money. So, the British scrapped the incentive, causing the cobra breeders to set the now-worthless snakes free, exploding the local snake population. The apparent solution for the problem made the situation even worse as the British didn’t think beyond first-order consequences.

Garrett Hardin’s Law of Ecology
You can never merely do one thing.

Plain English

First-order thinking is the fast and simple understanding of the basic implications of a decision. This mode of thinking only solves the immediate problem without considering the consequences. For example, I’m tired today, so I’ll skip the gym. Falling victim to short-term, first-order thinking is common and not surprising because it is linear, easy, straightforward, and fast.

I mean, there’s a lot of consequences to everything. You never can do just one thing in economics, you always have to say, “And then what?”

– Warren Buffett, Interview with CNBC

Second-order thinking is the process of coming to understand, as best as you can, the implications of those first-order impacts – the effects of effects. Looking beyond the pebble, you drop into the water to the ripples it produces. This type of thinking is non-linear, complex, and probabilistic. You must be able to think of the implications your actions will have through time and on different counterparties, understanding that actions always have implications and unintended consequences that are difficult, if not impossible to predict. While this type of thinking is unnatural and difficult, it is powerful because second-order effects often dwarf the first, yet often go unconsidered.

A useful personal rule might be: do things which have negative first-order (short-term) consequences but positive second-, third-, fourth-order (long-term) consequences. Why? Humans have not evolved the ability to easily think non-linearly or act long-term, so these actions are likely rare and able to provide Advantageous Divergence. When you do as everyone else does, don’t be surprised to get what everyone else gets.

There is only one difference between a bad economist and a good one. The bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

– Frederic Bastiat

Technical Description

Second-order thinking is being able to take into account not only the impact of your actions but the impact your actions will have on the situation and others.

Quotes

First-order thinking is any type of thinking that is about something other than thinking itself. Second-order thinking is thinking about thinking.

– Kevin Maurice

There’s an old riddle about ten birds sitting on a telephone wire. A hunter shoots one. How many are left? The usual response is nine. But the correct answer is none; the rest are frightened by the gunshot and fly away. Maybe it’s a joke, but it illustrates the ease with which ramifications – what my British friends call “knock-on effects” – are overlooked…The longer I think about economic and investment trends, the more I view every development as a reaction to something else. And you’ve probably noticed my inability to talk about current events without discussing their precursors.

– Howard Marks, The Aviary

Some of the biggest problems arise because market participants think of their environment as a static arena in which they act. What they miss – to their frequent detriment – is that their actions alter the environment, causing the results to differ from their expectations.

George Soros has written and spoken most articulately about the ability of investors’ actions to change the environment. He calls this process “reflexivity.”

The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy. (George Soros, MIT Department of Economics World Economy Laboratory Conference, Washington, D.C., April 26, 1994).

– Howard Marks, Touchstones

Since participants set security prices, it’s their behavior that creates most of the risk in investing. This is true in many other activities as well, the common thread being the involvement of humans.

Jill Fredston, an expert on avalanches, has observed that “better safety gear can entice climbers to take more risk – making them in fact less safe.”
When all traffic controls were removed from the town of Drachten, Holland, traffic flow doubled and fatal accidents fell to zero, presumably because people drove more carefully.

– Howard Marks, Ditto

Separating proximate from ultimate causation frequently leads to better understandings of the events and systems concerned.

– Neil Greenberg

Keynes described the action of rational agents in a market using an analogy based on a fictional newspaper contest, in which entrants are asked to choose the six most attractive faces from a hundred photographs. Those who picked the most popular faces are then eligible for a prize. A naive strategy would be to choose the face that, in the opinion of the entrant, is the most handsome. A more sophisticated contest entrant, wishing to maximize the chances of winning a prize, would think about what the majority perception of attractive is, and then make a selection based on some inference from their knowledge of public perceptions. This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus, the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational agents.

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

Keynes believed that similar behavior was at work within the stock market. This would have people pricing shares not based on what they think their fundamental value is, but rather on what they think everyone else thinks their value is, or what everybody else would predict the average assessment of value to be.

– Keynesian Beauty Contest

The three filters operate through these particular questions: Literacy: What are the words? Numeracy: What are the numbers? Ecolacy: And then what?

– Garrett Hardin, Filters Against Folly

Those who have knowledge don’t predict; those who predict don’t have knowledge.

– Lao Tzu

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