Mental Models: Higher Order Thinking

Howard Marks, the chairman and co-founder of Oaktree Capital Management, is renowned for his insightful assessments of market opportunity and risk. After four decades spent ascending to the top of the investment management profession, today he is sought out by the world's leading value investors, and his client memos brim with insightful commentary and a time-tested, fundamental philosophy.In his book, The Most Important Thing,

Howard Marks explains the concept of first and second-order thinking, which he calls second-level thinking.

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex and convoluted.First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”

First level thinking is simplistic.  It occurs when we want a fast fix. It does not take consequences into consideration. If you are hungry, you eat.

Second level thinking is more considered. It considers context, alternatives, and unintended consequences. Second order thinkers ask themselves the question "Why?" or "Then what?" to deepen their understanding of an issue. If they are hungry, they consider the consequences of eating when they are hungry versus the time of day or circumstance in which their hunger strikes. They make connections, draw correlations, and notice nuance. Doing this, they are likely to make healthier choices when addressing their hunger.Remember here that consequences are not always negative. Positive outcomes are consequences too.

Short term bias and negativity bias are actually first-order-thinking biases

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Humans don’t have a negativity bias. We miss long term trends regardless of whether they’re good or bad. The root cause that makes us miss them is not that we are biased towards short-term choices (that’s a byproduct). Our negativity bias and short-term biases are byproducts of a first-order-thinking bias. Our brain is wired to be unable to perform second-order-thinking while thinking intuitively: therefore, the bias. --via Luca Dellana

With first-level thinking, everyone reaches the same answer. This is where quick fixes and easy answers abound. With second-order thinking, we are all deeply interpreting the same situation uniquely. We apply our unique perspective. We see what others cannot.

Example excerpt from “It’s Not Easy: Memo To Oaktree Clients” by Howard Marks

Improve Your Thinking, as a skill

Now that you know this kind of thinking exists, what will you do differently today? Here's how you can practice it now:

  1. Ask yourself "Why?" "What's It For?" or "Then What?

  2. Think through time — What will the situation be in 1 hour, 1 day, 1 month, 1 year? How will that impact the consequences?

  3. Identify your problem-solution-decision. Consider the pros-cons. Think through the consequences. Reviewing these on a regular basis will help you calibrate your thinking more nimbly.

  4. (Bonus) If you’re using this concept to think about business decisions, consider how it impacts other areas of your ecosystem. How will key players respond? What meaning will employees make of it? How will stakeholders deal with it? How will competitors respond? How will suppliers react? What regulations are we likely to incur?

Often the answer will be little to no impact, but you want to understand the immediate and second-order consequences before you make the decision.The difference of a second-level thinker is effort:

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 think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions…To outperform the average investor, you have to be able to outthink the consensus.

Getting to the next level, in anything, is the result of things that are first-order negative, second order positive. A situation might appear to have no immediate benefit or payoff, but that doesn't mean that's the case.  What it indicates is that there is less competition if deeper thinking yields positive outcomes because everyone who simplistically won’t think things through.Second-order thinking takes effort, effort most people will not invest. It takes effort to think in terms of systems, interactions, and time. But investing this kind of effort sets you apart from everyone else.