Why 'second-order' thinking is a powerful tool for money management

Second-order thinking will help investors pay less in terms of financial advisory fees, but keep more of their returns in the long term. Corbis

In my last column, I spoke about the world’s great mental models — models we all have in our heads. The quality of our life depends on them.

For this column, I wanted to touch on second-order thinking because, perhaps more than anything else, it helps us analyse the long-term impact of our decisions.

Often when solving one problem, without realising, we create another worse one. This is often easy to spot.

Some might say former UK prime minister Liz Truss didn’t fully think through the second-order impact of her mini-budget tax measures, which led to shattered confidence among financial markets, a plummeting pound, a meltdown in the UK bond market and, ultimately, her political demise.

The ability to think through problems to the extreme — or second-order thinking — is a powerful tool to supercharge your thinking.

First-order thinking is quick and easy. We try to solve the immediate problem without considering what happens next.

“I’m hungry, I’m going to eat cake,” for example. Hunger and sugar cravings solved.

Second-order thinking is more thoughtful — thinking in terms of interactions and time. It considers that, despite our intentions, what we do often causes harm.

What happens, for example, when you repeatedly eat cake when hungry and use that analysis to inform your decision (if you do this, you’re more likely to eat something healthy).

First and second-order thinking appear the same. But if you want to out-think someone, you can’t do it with first-order thinking.

It must come from second-order thinking. Extraordinary performance comes from seeing things that other people can’t.

Here are three techniques for you to start using second-order thinking today:

1. Always ask yourself “and then what?” over and over again when faced with a decision.
2. Think through time — what do the consequences look like in 10 minutes? 10 months? 10 years?
3. Think through and write down the consequences of your decision. If you review it regularly, you’ll be able to help calibrate your thinking.

Say you’re a business owner — you can use the above to think about business decisions and ask yourself how important parts of the ecosystem are likely to respond.

Often, the answer will be low in impact but understanding the immediate and subsequent consequences before you make the decision is key.

Often, a lot of extraordinary things in life are the result of things that are first-order negative, second-order positive.

This could be said of my personal mission to change how the “broken” financial services system works.

Some might say former UK prime minister Liz Truss failed to consider the second-order effects of her mini-budget tax measures. PA

For example, I believe investors should pay less and get to keep more of their returns.

Because I charge a fee rather than take a commission, I need to drive down the cost of investment while maintaining some level of profitability to survive. This is horribly hard.

But over time, charging less and not taking commissions drives up the returns my clients receive.

They’re happy, trust me more, give me more money and introduce me to their friends.

I manage more money, get greater economies of scale and, therefore, reduce the costs that my clients pay, while maintaining profitability.

The circle self-perpetuates. It is win-win; driving costs low and returns higher for everyone involved.

Hard to start, but powerful once ignited. A first-order thinker just takes jam today and is arguably “short-term” greedy, thereby sacrificing everyone’s tomorrow.

Second-order thinking takes work. It’s not easy to think in terms of systems, interactions and time.

However, doing so is a smart way to separate yourself from the masses.

Sam Instone is co-chief executive of wealth management company AES