Second Order Thinking
Second Order Thinking is a critical practice for making effective policy, business and personal decisions. Many of our self-created problems as a society are due to people’s lack of Second Order Thinking.
What is Second Order Thinking?
First order thinking is the process of considering the intended and perhaps obvious implications of a business decision or policy change.
Second order thinking is the process of tracing down and unraveling the implications of those first order impacts.
In a similar vein, in his excellent book The Most Important Thing revered investor Howard Marks writes about the importance of “Second Level Thinking” He introduces this topic with the following:
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 out-look stinks, but everyone else is selling in a panic. Buy!”
Similarly, Benedict Evans wrote a piece, Cars and second order consequences, in which he explores what might happen in the economy if personal cars are replaced with self driving on-demand cars and/or if gas cars are replaced with batteries.
Here he explores some obvious first order effects such as pointing out that half of global oil consumption is used to produce gasoline. Reducing gas consumption is a clear first order effect of EVs.
Next he explores how changes to driving and fueling technologies could have radical consequences for ranging topics from parking/accidents (somewhat obvious points) to tobacco consumption given that over half of cigarettes are purchased gas stations (much less obvious). The impact on cigarette sales would a second order effect.
Most people don’t do second order thinking because it’s hard. It’s uncertain. It adds complexity. Second order effects don’t fit onto bumper stickers.
Howard Marks follows up after the above quote to make clear that second level thinking is far different from simple contrarianism:
•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.
Why invest in second order thinking?
More and better second order thinking will serve us well in domains of life, business and government. When we ignore second order effects we end up with grave errors born of our hubris.
Take as example the Cane Toad — a species of rapidly replicating poisonous toads that were introduced to Australia (amongst other places) to control agricultural pests. These animals are now considered an invasive pest themselves and have wreaked havoc on wildlife.
First order thinking: These toads will kill the pests we hate.
Second order thinking: These toads are poisonous and have no natural predators here. Soon they will be the pests.
The entire debate around global warming is so difficult because global warming is a second order effect. It’s murky, hard to understand and complex — but the impact on people’s lives is very real.
Hot socio-political issues such as taxation, immigration, tariffs, rent control, zoning, minimum wages are all minefields of second order effects. Business or technical decisions you’re making at work likely have second order effects. Are you considering them?
How to do second order thinking
Thinking carefully about the second order effects in a complex environment is not new. Indeed there’s a whole field of systems theory that encourages us to think about feedback loops.
A simplistic and flawed approach I find useful is to think:
If we make this change can we enumerate the first order effects? What will the effects of those first order effects be?
I also try to pay special attention to incentives (i.e. feedback loops) in any system that involves humans.
A great example of incentive structures can be found in the now famous study showing that introducing a late pickup fee at a daycare ended up legitimizing the very behavior it was meant to discourage.
Howard Marks outlines his process for second level thinking as a series of questions to inspect:
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?
This sort of thinking is reasonably common amongst academics and professional investors. It’s present but perhaps not common amongst business leaders. It’s exceedingly rare amongst most people and seemingly completely absent from the minds of politicians.
We ignore second order effects at our own peril.
Do you practice a form of second order thinking? I’d love to hear from you. Send me your thoughts — @noahmp on Twitter.
