What is 1st and 2nd-Order Thinking?

1st and 2nd-order thinking are thought processes that we go through when analysing situations in all aspects of life. 1st Order thinking is not inherently bad, but it is essential to try to think better and apply Second Order thinking when necessary. The Second Order thought process requires energy, problem-solving skills, critical thinking, and looking into the future at the consequences of your decisions.

Our brains are hardwired to think around a few simple levels. Thinking deeper is complex.

Most of the time, first-level thinking is sufficient. You don’t need to question everything all the time. For example, when you are thirsty, you drink water; you don’t need to go through levels of consequences. Similarly, when you see a red light, you stop the car; you don’t need to go through second-order consequences of whether you should stop. First-level thinking is simple, carried out on auto-pilot, and is quite necessary for a large part of life ie. Flight or fight.

However, there are misconceptions about First-Order thinking, how poor it is, and how superficial it can be. Yes, it can be when directed at areas of your life that require a better decision-making process, such as money decisions or career decisions. Thinking past the excitement, the initial emotional feelings, moments of euphoria, and thinking – What if? If this occurs, then what? And then, after this?

Second-order thinking is best applied where it is required, such as financial decisions, decisions that have some form of consequences beyond a fast decision. Second-order thinking moves beyond the immediate problem and forces you to consider the various outcomes and consequences of a given decision. It looks past the simple First-Order outcome of a decision and explores the second, third, and Nth-order effects from each layer of possibilities.

How can 2nd-Order thinking help investors?

Investing should not be approached with first-order thinking. Investing your hard-earned wealth must not be treated like gambling or like buying a new appliance for your home. Most investors spend more time researching and thinking about the new TV they want to buy than they do on a new investment position.

First-order thinking can be like earning good money and thinking, “I am young, let’s spend it all, buy what I want because YOLO!” Second-order thinking, on the other hand, looks beyond the first decision and considers the future consequences of that decision. It thinks, “I will get older, and perhaps I won’t want to work as hard. What will I do for income then?” It can develop a plan based on a deeper level of thinking.

Applying second-order thinking to investing is crucial. It involves finding companies, evaluating information, portfolio structuring, and more. It forces you to pause and consider, “If this, then what?” For example, first-order thinking may look at a company and suggest, “It is trading on a low price-to-book ratio. It is undervalued. Let’s buy.” 2nd-order thinking, however, looks beyond this and thinks, “It is trading on a low price-to-book ratio. Why? What is causing this to be so undervalued? Is it a value trap? Can it turn around, and if so, what is the likely value behind this?”

In other words, before buying a company, it’s essential to think deeply about it. Don’t just assume that a company is cheap and buy it. Ask yourself, “Does it deserve to be cheap? Does it have a future?”

Think deeper in terms of consequences and probabilities, ask, “and then what?”

When it comes to investing, it’s important to consider all aspects. Sometimes, a company may be experiencing a hyper-growth phase or have a hot IPO. During these times, investors may become irrational and act on their fear of missing out.

However, second-order thinking can help in such situations. For instance, when evaluating a hot stock, look at the current multiple associated with the company, and consider its earnings projections. If it’s already trading at a high multiple and isn’t earning yet, it’s worth considering whether the projected earnings would justify such a high valuation.

Additionally, it’s essential to think about the probability of the hot stock achieving a market cap similar to that of well-established, profitable, and dominating companies. By applying second-order thinking, investors can make more informed decisions and avoid irrational behaviour.

Investors can apply deeper levels of thinking in all aspects of their financial decision-making process. Whether it is to do with portfolio structuring, asset classes, or risk tolerance, all of these require a much deeper layer beyond the 1st level.

Inversion is a form of 2nd-Order Thinking.

I have found Inversion Theory very helpful and I believe it is a valuable technique for 2nd-order thinking. Inverting ideas involves considering consequences from a different perspective, thereby encouraging deeper thinking. This approach can be applied to all areas of life. For example, when asking yourself why you are not happy, invert the question to ask what would make you unhappy and avoid those things.

Inversion can also be applied to investing, and here are some simple ideas to get started. It involves examining an idea from different angles to gain a deeper understanding. For instance, before following through on a request to take out the trash, ask yourself what would happen if you didn’t, and then proceed accordingly. You have to start with the end in mind, inversion asks you to consider the opposite of your result.

What should I invest in? ↔️ What should I avoid?

Why should I invest in this company? ↔️ Why shouldn’t I invest in it?

I can make 10% ROI with this idea. ↔️ How could I lose my capital from this?

How can I make money from this opportunity? ↔️ How could I lose money?

This company can be worth $x in 5 years? ↔️ What would cause it to fail?

I might start investing for my future ↔️ What if I don’t start investing for my future?

In short, always ask yourself, “What is terrible about this?” What could go wrong?” it is a contrarian mindset by nature. Looking for the consequences.

In Summary…

Logical investors think beyond an immediate decision and consider all the layers and any implications. This thought process can have tremendous results on your long-term success in markets and life. The issue with First Level thinking is it often confirms our biases as we don’t want to be uncomfortable or have our opinions challenged. Pushing beyond into the 2^nd and 3^rd levels can combat a lot of irrational investor biases we may have.

We often come across opportunities that seem great at first glance and without much thought, we jump into making investments, forming relationships, or pursuing business ventures. However, it’s important to consider the potential consequences of our actions beyond the immediate benefits.

Sometimes, saying “no” to an opportunity can save us from a lot of pain down the line. Although it may be uncomfortable in the short term, we must fight against our natural biases to think more deeply about our choices and consider the potential outcomes that lie beyond the first level of decision-making.

This 2nd-order thinking and inversion thinking process takes time, however with discipline and continuous practice it becomes a very useful way to approach decisions. You have to question everything, think along the lines of “What if?”, and create a roadmap of where you want to go and the possibilities to get there. Turn situations and problems upside down, and look at them backward. Sometimes our first ideas are not great but sometimes they are the best ideas, invert them anyway.