The Cobra Problem: Second-Order Thinking

‘The economy is slowing; it’s time to sell.’

‘It’s a disruptive sector which is increasingly popular.’

Have you ever been guided by statements like this? If so, you’ve probably fallen victim to first-order thinking. It’s a common problem, with an easy fix. But before explaining first- and second-order thinking, let’s step back in time to the early days of British colonial rule in India.

THE COBRA PROBLEM

The first British settlers in India had to adjust. Climate, culture and cuisine posed unique challenges. But one summer a cobra infestation in Delhi forced the colonial government to act.

After putting heads together, the British governor decided to incentivise the locals to kill cobras. As such, he created a reward in exchange for cobra skins. By offering money for dead cobras, the governor believed in an easy way to solve the problem. But he didn’t think through the consequences and the local population spotted an opportunity.

Rather than killing wild cobras, the locals began farming more cobras for their skins! Farmed skins, rather than wild skins, were being traded in for money. As such, the British were bleeding money without solving the underlying problem.

Realising the error of their ways, the British cancelled the scheme. However, this response was also short-sighted. Not only did the British lose money, but with no more reward available, the cobra farmers released their now-larger population of cobras into the city, making the infestation even worse than before.

FIRST-ORDER VS SECOND-ORDER THINKING

This Cobra problem is a prime example of first-order thinking. A first-order thinker only considers what’s happening right now. For example, they would see the economy slowing down and decide it’s time to sell their investments to hold cash instead.

The issue is that this thinking ignores other people’s responses to the initial fact. If you are the first person to realise that the economy is slowing, and asset prices are high, perhaps it makes sense to sell. But if everyone else is also selling, and asset prices have already fallen, then your judgment to sell is too late. You need to understand what other market participants have already done in response to the fact, before making your judgment.

In this example, the economic slowdown could yield three outcomes:

• If the economy is slowing and no-one has acted, you might do well to sell while you can still receive a high price for your investments. The problem is that by the time you’re aware of slowing growth, the professional investors will already be aware and will have sold before you, driving down the price… So if you sell, you will be doing so at a lower price.

• If the economy is slowing and prices have already fallen, perhaps you’re best off doing nothing – because price falls have already reflected the deteriorating economic outlook.

• If the economy slows and prices have fallen dramatically, perhaps you’re better-off buying more, because market participants have already assumed a deep recession, and sentiment can’t get much worse.

To be clear, we’re not advocating ‘market timing’ – but rather showing how first-order thinking is too simplistic.

Second-order thinking is about seeing not only what has happened, but what will be the knock-on effects in the future.

First-order thinking sees a good company and decides to buy its stock. Second-level thinking sees a good company, which everyone else believes to be a great company, and it’s not. So the stock is overrated and overpriced, meaning we should sell.

First-order thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-order thinking says, “The outlook stinks, but everyone else is selling in a panic. Buy!”

A FRAMEWORK FOR SECOND-ORDER THINKING

Understanding this distinction between first and second-order thinking is crucial, because it prevents simple mistakes. In investing, it avoids being swept up with the crowd, and buying expensive assets in a bubble. It also prevents selling at the market bottom, when the economic or company outlook is at its worst.

Having a checklist of questions will help you avoid the cobra trap and see into the long-term. Here are some ideas:

• After the obvious, what could happen next?

• What is my view?

• What is the consensus view and how does it differ from my view?

• What is the probability that I’m right?

Successful application of second-order thinking will help you distinguish between value (what an asset is really worth) and price (what market participants are willing to pay for it today). Value typically changes little, but price can be extremely volatile.

Having the anchor of value in mind, you’ll be able to watch unemotionally as price moves far below value (the time to buy) and far above value (the time to sell). And you’ll avoid buying into a company or a market just because it seems promising – you’ll use the second-order thinking checklist to determine whether you’re swayed by other people’s thinking.

Most common investing mistakes are caused by first-order thinking, but it needn’t be that way. A longer-term view – avoiding the Cobra Problem - is worth its weight in gold.