Source: http://musingzebra.com/second-and-higher-order-effects/

There is a story where a toll bridge at Delhi is always congested during rush hour. Therefore, the officials decided to keep it toll-free between 8 to 10 am and 5 to 7 pm to ease the traffic. What they didn’t expect is drivers arriving 30 mins before the toll-free period started queuing up in front of the bridge, thereby worsening the traffic condition.

Those drivers’ waiting for the toll-free period is a second-order effect, an unintended effect resulted from the policy’s original intention to solve a specific problem—traffic congestion. Second order effect is a common feature of an interconnected system such as society, ecology, and the stock market. Also called ripple effect, an effect tend to set off a chain reaction that becomes the cause of other unexpected events—consequences have consequences have consequences have consequences. These unexpected events can either reinforce the first order effect or act as a negative force to reverse it, such as the story above.

In Thinking in Systems, Donella Meadows explains a system consists of 3 things: Elements, interconnections, and function or purpose. In the example above, you have a system that consists of drivers, bridge (elements), toll policy (interconnections), destination, and time/cost savings (function or purpose). Changes in an element, such as replacing those drivers with another set of drivers, has minimal effect on how the system function. However, changes in interconnection or function/purpose within a system can alter the system dramatically. When the bridge become toll-free, it alters those drivers’ behavior. This is also known as a complex adaptive system.

Most interconnected systems are a complex adaptive system which individuals are adaptive to their environment to achieve their own purpose. In a football game, the coaches and players (elements) adapt to their opponent’s strategy to win the match (purpose). In ecology, if a frog has a sticky tongue to catch more preys, its preys will evolve to have a better defense mechanism like slippery skin or faster flight speed to counter that. This is the same with the stock market.

Imagine the stock market as a congested, but flowing, two-lane, one-way street. The right lane is shorter and less congested than the left lane. Therefore, some drivers on the left lane decided to switch over. This causes the right lane to become longer while temporarily leaving the left lane shorter. Some drivers who initially planned to make the switch but haven’t now find that it is more advantageous to stay. But as more drivers prefer the left lane, it will reach a point where the right lane becomes more favorable again. This is a simple analogy of how the market adapts to the prediction of the crowd and changes the outcome. Or consider a market crash. If the market correctly predicted a market crash is on the horizon and take drastic measures to prevent it, the crash will never happen because of those precautionary steps. The opposite is just as possible. If the crowd predicted a crash when there is actually none, those precautionary steps might turn into a self-fulfilling prophecy that triggers the crash. These scenarios have different outcomes but same conclusion: prediction introduce second order effects which change the outcome.  

What does this mean for you? You have to think in second and higher order effects whenever you are dealing with interconnected systems like the stock market. Or what Howard Marks called the 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. Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account.”

Second-level thinking is about seeing things from multiple perspectives like a dragonfly’s eyes by considering what can possibly happen. Consider this. Imagine a sales team from a giant equipment manufacturer makes a sales pitch to a struggling food company that their state-of-the-art machine can lower the company’s production cost by 50%. After doing some back-of-the-envelope calculation, the CEO of the food company found this investment (buying the machine) has a positive net present value (NPV). NPV is a financial tool used to determine the profitability of an investment. The rule is straightforward: Invest if an investment has a positive NPV values; reject if negative NPV values. So this is a no-brainer decision. The CEO should buy the machine, lower the production cost, and improve their operating margin. But the CEO—a 35 years veteran in the industry, is already thinking one step ahead. He knew the manufacturing giant has every reason to sell this state-of-the-art machine to all of his competitors, given the fact it cost millions of dollars in R&D to build it. Now, if one of his competitors who got his hand on the machine decides to reduce their selling price to capture more market share, which is highly possible due to the high fixed cost nature of the business and scale advantage, this will quickly turn into an all-out race to the bottom. When the competitor lowers their selling price by 1%, the rest will follow suit in order to maintain their market share. Some would reduce even further just to wrestle back their stolen market share. He knows where this is going. Little by little, all the 50% cost savings will get squeezed out and passed onto their happy customers in the form of lower price, leaving him and his competitors back to square one with the same poor margin before the investment, with the exception of getting stuck with another piece of costly machine.

Second-level thinking helps avoid satisficing such as making assumptions based on the first answer that comes to mind. By thinking several steps ahead and constantly asking what if, you can gain more insights and plan ahead for any unexpected consequences. You are also less likely to be surprised or panic when something goes wrong because you’re better prepared. In addition, you have a mental filter that prevents you from being fooled by your own biases or someone else’s opinions.

A simple way to cultivate second-level thinking is to simply ask “and then what?” If you concluded that oil stocks are going to go up because an increase in oil price will improve their earnings, and then what? If earnings improve, they might be motivated to invest more to increase supply which might cause the oil price to go down. You think in decision tree where an event might lead into several possible pathways and weight on the likelihood of each scenario happening.

If you find this helpful, share it & subscribe to be a better investor.