Guest Author – James Andrews
Family Movie Night
My family has a standing tradition where Friday evenings are family movie nights. It’s a special time we set aside to transform the family room with a collection of pillows, blankets, and stuffed animals for our two boys (ages 5 and 3). We typically make homemade pizzas and choose a special movie, and at this time of year, we add the beautifully decorated Christmas tree, a garland along the mantel with twinkling lights and a fire in our fireplace. It’s a treasured time of family cuddles that we all love. Since I am a known napper in the family, it’s likely no surprise that I often fall asleep cozied with the boys on the ground.
During a recent family movie night, our youngest (whom we lovingly refer to as a tornado) saw an opportunity he couldn’t pass up. While I was dozing peacefully on the floor, he quietly got up, turned around, and body-slammed my sternum like a 40lb freight train. While gasping for air, I react (poorly reacted, I admit) and throw a “tornado” across the room, where he lands on the laminate floor – crying. My 5-year-old is laughing hysterically, and my wife screams while running to check on our youngest. In one second, our peaceful family evening turned into utter chaos that my 3-year-old never anticipated. He simply wanted to play a prank but failed to realize what might happen next, or next after that. He neglected to grasp second-and-third-order consequences.
Anticipating the Future
Second Order Thinking is the discipline of looking beyond the initial consequences of a decision, to the 2nd and 3rd consequences that would follow. For example, choosing to eat a candy bar because you’re hungry meets the immediate need for hunger but can lead to poor health if the behavior continues. Or selling a stock because the price dropped suddenly to avoid some near-term pain, missing the longer-term opportunity of a late-stage rally. Ray Dalio (Founder of Bridgewater Associates) described Second Order Thinking this way:
“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.”
The ability to think through the cascade of consequences from a decision is a powerful method to enhance wealth creation. Many of us already know the benefits that come from careful thought, so this topic is less about why Second Order Thinking is so important and more about how we can seek to apply it in more areas of life. I believe there are two common reasons why we do not employ this type of thinking more often: (1) we prioritize immediate benefits over pain, and (2) our brains are wired to offer quick solutions with as little thought effort as possible.
Cake Now, Gym Later
When faced with a decision where one door offers difficulty, and the other door offers comfort, it’s no surprise that we often default to the comfortable option. For example: choosing to sleep in over the gym, ordering take-out instead of cooking dinner, or lowering a 401(k) contribution to allow for a more comfortable lifestyle. Early in my career, I had the privilege of working as an analyst on a Mergers & Acquisitions team where we purchased various companies. These negotiations had dozens of moving pieces around financial incentives, terms, timing, and payment options, to name a few. As the team’s financial analyst, one of my jobs was to work on the financial structure of the deal that offered the acquisition target a tempting near-term payoff while my company enjoyed the longer-term upside. In other words, offering the acquisition a smaller upfront benefit so that we could capitalize on a larger benefit down the road. The inclination toward immediate comfort over difficulty is a common human tendency that manifests itself across all areas of life and proves to be a useful negotiation tactic when other individuals fail to consider the 2nd and 3rd order of events.
In many cases, our thinking framework would benefit from asking, “And then what?” when confronted with options. What happens if I continue to eat out for meals, lower my 401(k) contribution, or hold on to my appreciated stocks in the avoidance of capital gains taxes? Ask yourself what would happen if you continued in a decision for 2 months, or 2 years.
Fighting Brain Fatigue
The second reason why many people struggle to apply Second Order Thinking is from brain fatigue. Economist and Nobel Laureate Richard H. Thaler wrote a ground-breaking book titled Nudge that offers key insights into people’s ability to make decisions. He identifies two cognitive systems in all of us: System 1 (Automatic) and System 2 (Reflective).
“The Automatic System is your gut reaction, and the Reflective system is your conscious thought. Gut feelings can be quite accurate, but we often make mistakes because we rely too much on our Automatic System… The picture that emerges is one of busy people trying to cope in a complex world in which they cannot afford to think deeply and at length about every choice they have to make. People adopt sensible rules of thumb that usually work well but sometimes lead them astray, especially in challenging or unfamiliar situations… they tend to accept questions as posed rather than trying to determine whether their answers would vary under alternative formulations.”
When presented with the investment choices available (along with the abundance of opinions, information, data, trends, etc.), many investors tend to default to their “gut feeling” to cut through the noise, not realizing that they are delegating decision power to their System 1 (Automatic) in lieu of System 2 (Reflective), thereby missing out on the wonderful benefits Second-Order thinking can bring over time.
Decisions with a Future Focus
The compelling truth is that many parts of life that bring first-order negative consequences often lead to the greatest 2nd and 3rd order benefits. To name a few:
- Rebalancing your portfolio at a gain (thereby realizing taxes) to reset for a new market environment.
- Roth Conversion techniques, where taxes are incurred today, to reduce taxes in the future.
- Bringing heirs into the family wealth early (risking loss of principal and time) to develop healthy money habits in the future.
- Avoiding the temptation to join the momentum trading of a specific stock, losing out on possible near-term gains.
I’ll end with an excerpt from Shane Parrish, a thinker who I admire, that summarizes this well:
“A lot of extraordinary things in life are the result of things that are first-order negative, second order positive. So just because things look like they have no immediate payoff, doesn’t mean that’s the case. All it means is that you’ll have less competition if the second and third order consequences are positive because everyone who thinks at the first order won’t think things through.”
James Andrews
Private Wealth Advisor
jandrews@thebahnsengroup.com
Trevor Cummings
PWA Group Director, Partner
tcummings@thebahnsengroup.com
