Using 2nd Order Thinking To Make Extraordinary Investment Decisions

Our ability to become successful investors is dependent upon making good decisions. We live in a golden age where we have access to all kinds of quantitative and qualitative information. Despite the mountain of information and data at our fingertips, we struggle to make consistent, successful investment decisions that lead to superior performance. A big reason is we try to make it a sanitized process when in fact making investment decisions is a rather dirty exercise. The problem is we believe we need “perfect”, clean and complete information to make a successful decision. There is no such thing as perfect and complete information. Because of this, we run into analysis paralysis. Central Banks have been criticized for not being proactive and delaying major decisions (i.e. kicking the can down the road) because they are “data dependent”. They always want more information just to be 100 percent sure. The reality is making investment decisions is both an art and a science. Our decision to buy a stock or Exchange Trade Fund (ETF) is at best an educated guess because we have no guarantee that a company will perform as we think it will exactly in the future, despite the hours of analysis we’ve put into trying to figure out if it is.

Often, we frame our decisions based on a group think or herd mentality and make decisions based on who we are surrounded and associated with. We’re wired to aspire to be around the winning team or people who we perceive to be winners. We gravitate to Bay Street analysts for their recommendations because we perceive them as knowing something we don’t. We like to associate ourselves with the latest hot investing idea (marijuana stocks, artificial intelligence, low volatility ETF’s etc.) We make decisions based on technical indicators (earnings growth, dividend yield, cashflow yield) because they make us feel that we are using higher level thinking that will give us an advantage. These criteria are considered to be First Order elements which use a collection of formal systems such as mathematics, linguistics or computer science to make a decision based on quantified variables.

The reality is making investing decisions based on First Order elements that are superficial often leads to mediocre or unsuccessful performance because these factors are known by everyone. It just makes you average. As Howard Marks of Oaktree Capital said, “You can’t take the same actions as everyone else and expect to outperform.” When Bank of Montreal reports a strong quarter, the logic is the stock will go up. This isn’t unique because everyone will think the same way and the stock will move accordingly. The recent push by the investors into “passive”-oriented investment products like ETFs as well as new online wealth management platforms like Robo Advisors is based on First Order thinking to gravitate towards decisions to adopt simple, easy, defendable investments. First Order thinking says it is good enough to stay in the game and have exposure to all the stocks in the S&P 500 index rather than having no exposure at all. You’re in the game but understand your chances of getting extraordinary growth will be limited. For many that will suffice and that’s fine.

Mr. Marks believes exceptional and successful investment decisions are achieved by adopting Second Order thinking, which requires a more critical, but not cynical examination of an investment opportunity. Second Order thinking goes beyond looking at surface level metrics of earnings and debt/equity ratios. It requires challenging those established data points and asking questions (How sustainable is the company? What could go wrong? Will customers continuously buy their products and services?) Second Order thinking requires you at times to take a contrarian position and go against the conventional thinking. It also requires an appreciation of context. When Apple says they sold twice as many phones as the population of Canada in the most recent quarter that should provide better context on how financially strong their business is than the indifference of a Bay Street analyst who is focussed on quarter-to-quarter comparisons. Because we have no idea what will happen in the future, we need to think about what could go wrong with a business and map out scenarios and probabilities around it. It won’t be perfect information we are basing our decisions on, but it will give us a better chance to achieve higher returns if we apply a strict investing ideology and maintain the discipline to stick with it through good times and bad.

Second Order thinking does not mean adopting the George Costanza approach of doing the opposite of what everyone is doing every time. Simply being different and wearing a pink shirt when everyone is wearing white does not equate to investing success. You still need to be correct. You still need to do your due diligence. Successful investors strive for being correct and then try to improve on them a little bit at a time while controlling their losses (because they will also make bad decisions.)

Adopting Second Order thinking is not easy. It requires you to zig while others zag and you may look quite foolish doing so. It’s tough because we all have loss-aversion biases and don’t want to look dumb. The best way to develop a Second Order thinking mindset is to develop an awareness of the many behavioural biases that often cloud our decision making such as chasing past performance and managing those behaviours. It requires embracing new ideas and perspectives that are out of our comfort area, as well as developing an investing ideology and committing to it for the long-run. As Charlie Munger once said, “It’s (investing) not supposed to be easy. Anyone who finds it easy is stupid.”

Aman Raina is an investment coach and founder of Sage Investors.  Aman can be reached through his website (www.sageinvestors.ca), Twitter (@sageinvestors)