☕ How Second-Order Thinking Avoids Costly Mistakes
Friday: Mental Model / Big Idea
This whole concept is simple but not easy. I think Ray Dalio sums it up nicely:
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
In his 2015 letter, Howard Marks drives the idea so well. This is one of my favorite blurbs in investing:
Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others — both more powerful and at a higher level. Since others may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different. . . .
For your performance to diverge from the norm, your expectations — and thus your portfolio — have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.
That is second-level thinking in a nutshell.
I highly suggest you read this memo for yourself and keep it handy:
ttps://www.oaktreecapital.com/docs/default-source/memos/2015-09-09-its-not-easy.pdf
Marks goes on to give examples of questions that second-level investors/thinkers should ask regularly:
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?
How does the current price for the asset comport with the consensus view of the future, and with mine?
Is the consensus psychology that’s incorporated in the price too bullish or bearish?
What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
I hope this helps you in your journey.