Second-Order Thinking: How To Gain A Mental Edge

The mental model to outperform.

Have you ever experienced a situation where you wish you had made a different decision based on the information available at the time? Most of us have probably found ourselves in that position before. It’s easy to look back and realise what could have been done differently. But how can you ensure you’re making the best decisions at each moment?

Understanding how to think things through—to push your mind past the first step—can help you solve problems, avoid problems, and take better actions. This mental model is called “Second-Order Thinking.”

Let’s start with a definition. What are mental models? A mental model is an explanation of how something works. The phrase “mental model” is an overarching term for any concept, framework, or worldview you carry around in your mind.

Mental models help you understand life. For example, supply and demand is a mental model that helps you understand how the economy works. Game theory is a mental model that helps you understand how relationships and trust work. Entropy is a mental model that helps you understand how disorder and decay work.

Second-Order Thinking

The ability to think through problems to the second, third, and nth order—or second-order thinking for short—is a powerful thinking tool that not only solves problems but avoids them.

Let’s start at the beginning. Second-order thinking suggests that there is a step prior to this…

First-order thinking is fast and easy. Sometimes we make decisions based on solving a short-term problem without thinking about the long-term effects. For instance, it’s like feeling hungry and eating a chocolate bar without considering the health consequences.

Second-order thinking is more deliberate. It is thinking in terms of interactions and time, understanding that despite our intentions, our interventions often cause harm. Second-order thinkers ask themselves the question, “And then what?” This means thinking about the consequences of repeatedly eating a chocolate bar when you are hungry and using that to inform your decision. If you do this, you’re more likely to eat something healthy.

First-level thinking is common, where everyone arrives at the same conclusions. However, the real challenge lies in second-order thinking, which involves going beyond the obvious. Exceptional performance stems from perceiving things that others cannot.

We’re writing this today from the perspective of market participants. The same applies to trading and investing. Exceptional performance stems from perceiving things that others cannot.

“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

Now we have explained what it is, there’s a more important aspect to consider… how to do it. Here are three ways to put second-order thinking into practice today.

1. Always ask yourself, “And then what?”

2. Think about the consequences over time: What will they look like in 10 minutes, 10 months, and 10 years?

3. Identify your decision, think it through, and write down the consequences. Reviewing these regularly will help calibrate your thinking.

Second-order thinking takes a lot of work. It’s not easy to think in terms of systems, interactions, and time. However, doing so is a smart way to separate yourself from the masses.

Market Impacts

The idea to write about Second-Order Thinking has been there for a few months, sitting quietly in drafts until we got back to it. Listening to a podcast the other day brought the idea into action. It was Bloomberg’s ‘Odd Lots’. They were talking to a great market thinker,

Citrini

, the founder of

Citrini Research

, someone that we have had the pleasure of spending some time with.

It was great listening to Citrini discuss his ideas and thoughts. We’ll link the podcast at the end of this article. But during the conversation, the trio talked about some Second-Order moments in the market, which is what brought our attention back to this draft.

Firstly, you have the gummy bear shortage from the pandemic. Why? Let’s talk through the steps.

There was a large gelatin shortage in Mexico due to fewer hogs being slaughtered. Fewer hogs were being slaughtered because there was less demand for their hides to be used in the leather used in cars. There was less demand for leather in cars because fewer cars were being made. Now your mind may be able to connect the dots. There were fewer cars on the manufacturing lines because of the semiconductor chip shortage. Many new cars are heavily reliant on the inbuilt computer systems, which cannot work without these chips.

The latter part of that story was very popular news: a shortage of chips… buy semiconductor companies. However, the knock-on effect of this shortage caused a gelatin shortage. The biggest users of gelatin are gummy bear producers.

Another second-order moment happened in 2008.

In 2008, the price of milk was much higher than usual. An economist asked a dairy farmer, how come? The farmer said his inputs were much more expensive (within two years, it had gone up by a factor of four for some uses). He used sawdust to bed his cows more comfortably. They produced more milk when they were more often off their feet. The reason for the increase in the price of sawdust was the sharp downturn in the production of new housing. Since the construction of new houses was down, there was less sawdust.

So milk prices went up in part because an unexpected input into dairy farming (sawdust) was less available thanks to an almighty bust in housing and lumber production.

You may read these two examples and say to yourself, “Yeah, that makes sense.” But in practice, only the best minds comprehended these effects in real-time, all because of Second-Order Thinking.

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As mentioned, here is the podcast episode. Enjoy your weekend. We’ll be back tomorrow morning with our week ahead thoughts.