Mental Models #4: Second Order Thinking - Considering The Unexpected

What's up, everyone. This is Alex Lieberman, co-founder and Executive Chairman of Morning Brew. Welcome back to Founder’s Journal, my personal audio diary, where I give you, the business builder, the tools you need to think better in order to build better, whether that's building a business, a team, or a new product. We're doing things a little differently this week. We dropped our third mini-series, which means you got two episodes on Monday, two episodes today, and then two episodes on Friday. You are listening to episode four in the series, but be sure to check out today's classic episode as well. The theme of this week's mini-series is Mental Models. We're going to talk about some of the most powerful tools you can use to sharpen your thinking, prioritizing, and decision-making. Many of these tools have been made famous by leaders like Elon Musk and Dwight Eisenhower. And today I am talking about a mental model known as Second Order Thinking. Let's hop into it. 

What all successful people need

Think about the best people that you have ever worked with. How would you describe them? For me, here's what comes to mind. They are obsessive. They are a perfectionist. They think of everything. They just get it. They think three steps ahead. They play  4D chess. While illustrative, none of these phrases get to the core of what actually makes a special employee or founder special. And while I don't think you can sum it up in a single way, I do think there's a powerful mental model that can make you the person that is obsessive or thinks three steps ahead. And that model is called second order thinking. 

Very simply, first order thinking is considering the intended. Second order thinking is considering the unintended. To be a great entrepreneur, investor, or employee, you must learn how to become a great second order thinker. And Howard Marks, who is the founder of Oaktree Capital, and he's one of the most successful investors of all time, he believes deeply in the power of second order thinking so much, so that the first chapter of his book, which is called The Most Important Thing, is entirely dedicated to what he calls second level thinking.

2 great second order thinkers

So here are a few examples that Marks uses to illustrate what this looks like in practice. First level thinking says, it's a good company. Let's buy the stock. Second level thinking says, it's a good company, but everyone thinks it's a great company, which means any of the upside is already priced in. Another example, first level thinking says, I think the company's earnings will fall, so I should sell. Second level thinking says, I think the company's earnings will fall, but they're going to fall far less than other people expect. And because it will be a pleasant surprise because it's going to fall less than other people expect, it's actually going to cause the stock to go up, so we should buy. What Howard Marks makes clear with these examples is that to be a second level thinker, you need to go beyond the obvious. You need to grab higher than the low-hanging fruit intellectually.

And what I've found in my own work is the best way to do that is by asking yourself a set of questions when making any important decision or solving any difficult problem. So some of the questions that Howard Marks asks himself when making important investment decisions includes, 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? What will happen to the asset’s price if the consensus turns out to be right? And what if I'm right? Shane Parrish, who is a fantastic online writer who has a blog called Farnam Street, he does a similar exercise to Howard Marks, but he asks slightly different questions. His questions are, first and then what? Meaning once you make the decision and the obvious happens, then what happens? What's the non-obvious that will happen? He also asks, what do the consequences look like in 10 minutes from my decision, 10 months from my decision, and 10 years from my decision? And then specific to business, he asked questions like, how will employees deal with this? What will my competitors do? What about my suppliers? What about regulators? 

2 examples from business

And so now let me share two examples of how I've learned to use second order thinking in business, specifically with Morning Brew. When hiring someone senior, you think about exactly what you need in this person in order for them to be a great leader and for you to not mess up the hire. But what the second order thinker thinks about is all of the additional costs that come with hiring someone super senior. That person is going to want to hire a team. They're going to want to use their vendors or software they've used in previous jobs. When you pay for a senior leader, you're really paying for an entire part of an organization. That is the second order effect of hiring a great senior person. Here's another example, and it's specific to incentive plans and sales organizations: A first order thinker who wants to maximize the top line or revenue of their business is going to end up stretching quotas for their sellers and incentivizing their sales org to basically hit their targets with amazing accelerators, where they get paid a lot if they hit their sales goals. You want to know what that's great for? Incentivizing your salespeople to get new business and secure it. You want to know what that's not great for? Incentivizing salespeople to retain customers once the contract is signed. They couldn't care less about that because that's not how they're getting paid. 

Beware the cobra effect

Let me leave you with one last story that, while entertaining, is an amazing illustration of failed second order thinking, something called the cobra effect. Basically what happened was the British were ruling India and the city of Delhi was infested with cobras. And so the British wanted to get rid of this snake infestation, and so they enlisted the public. And basically what they did is they paid a bounty for any citizens in Delhi who would bring in cobra skins to show that they had killed the cobras. Problem was people were obviously incentivized to kill cobras, but what the British government didn't anticipate was how the people of Delhi were planning on doing that. So what ended up happening was this cottage industry formed where cobra farming proliferated. People were literally breeding cobras for their skins. So they would breed cobras, then they would kill the cobras. They bring them to the British government and get paid the bounty. And so what happened was the British paid out more and more money for these cobra skins, but the infestation didn't go down at all because there were all these farmers that were just breeding them. And so what ended up happening was the authorities ended up finding out about the cobra breeding. They stopped offering the bounty because clearly incentives weren’t right. And all of the cobra farmers just let the cobras go into the wild. You end up with more of a problem than you had in the beginning because incentives were perverse and the British government didn't think about second order thinking. And so in sum, to be a great second order thinker, you need to ask a lot of questions, you need to ask the right questions, and you need to get past the intended consequences of your decision and shed light and create full awareness of the unintended consequences of your choices. 

As always, thank you so much for listening to Founder’s Journal, specifically this episode on second order thinking. If you enjoyed, make sure to tune in to all six episodes this week that are part of our mini-series on Mental Models, and also make sure to pound the subscribe button for Founder’s Journal, whether it's on Apple, Spotify, or the podcast player of your choice. It is the number one way for us to grow our show.

Finally, if you do subscribe already, make sure to check out Founder’s Journal content on Morning Brew’s YouTube channel. Go to YouTube, search Morning Brew, and click on our channel. There you're going to see an entire playlist of Founder’s Journal videos, from how to deal with imposter syndrome, to why Ethereum matters, to how we were able to sell Morning Brew for eight figures. Thanks again for listening, and I'll catch you next episode.