One of the most enduring lessons I’ve taken away from my MBA degree is the concept of a “pre-mortem”.
Applied in a managerial / finance context, the idea is quite simple. Let’s say you are about to kick off a big project. It can be a greenfield infrastructure investment, a new product launch, or a corporate reorganization.
Before you hit the big red “Start” button, you pause to ask yourself:
“Let’s fast forward into the future and imagine this project ended up an utter, abject failure. What happened?”
The beauty of this approach is that it turns the frame of thinking on its head.
Instead of focusing on reasons why things may work out, it forces you to zero in on dangers that could torpedo whatever endeavour you are contemplating.
Then, once you have a good view of all the things that may cause your project to fail, you can look to find ways to mitigate the risks. Ultimately, the exercise gives you a much better chance of success.
The usefulness of the concept extends far beyond climbing the greasy pole in a corporate setting. In particular, it can help you make much better investment decisions.
Let’s say you want to jump on the bandwagon and buy yourself some Tesla stock.
Some of the reasons your investment may crash and burn include:
- Tesla is so overvalued that it never has the chance to “grow” into its multiple
- Something happens to Elon and the business withers in his absence
- The company is perpetuating an accounting fraud
- … and so forth
If you feel comfortable that the risks above have a low likelihood of materializing (or that you have a good way of hedging them), you are all set.
If not, Tesla probably isn’t for you (unless you’re just playing with some funny money).
Perhaps another time, Elon
Now, what if you were to ask the same question in the context of investing in an index tracker as opposed to an individual stock?
Interestingly, the list of questions would be quite different.
The beauty of diversification is that you are no longer exposed to company-specific risks. In corporate finance speak, index investing eliminates idiosyncratic risk. Unfortunately, you still have to bear what’s known as systematic risk.
So if you are about to plow your junior’s college fund into an S&P 500 tracker, you may worry about things like:
- The macro prospects for the US economy. After all, the S&P 500 constituents generate a meaningful portion of their revenues domestically
- The impact of currency fluctuations on the value of your investment, especially if you are located outside the US
- The likelihood that US financial markets will lose some of their structural advantages (regulatory, liquidity, depth, etc.). This may ultimately cause the future Amazons of the world to go public elsewhere – and depress your returns
- The S&P 500 valuation levels
I find the risks above relatively low likelihood – hence a significant chunk of our portfolio is invested in US equities.
Many others make the sensible decision to go for a world equity tracker. For them, the things that can wipe out their investment are as follows:
- A full-scale nuclear war (unfortunately, we’ve come pretty close before)
- A global environmental catastrophe
- An alien invasion
- [Let your imagination run wild here]
Incidentally, the very nature of these risks is a good reminder of why global equity investing is such an effective way to build wealth in the stock market.
Essentially, you are betting on the collective progress of the human race. And if things do go south, the value of your portfolio will be the least of your worries.
Put another way, you cannot fight off a zombie with your virtual share certificate!
Real Estate Pre-Mortems
Aside from the stock market, a pre-mortem can also be a very helpful tool in property investing.
Every time my wife and I buy a property, we ask ourselves:
“What are the risks that could cause us to lose money on this investment?”
Typical questions / answers include:
1. Structural issues with the property
This is why we never skimp on a good property inspection (and never put down unconditional offers, even in bidding wars).
2. Environmental issues with or around the property
Perhaps there a naughty gas station or an old, covered-up landfill nearby? Doing the leg work is important, but having good insurance is critical. Do your leg work, but ultimately make sure you’ve got good insurance.
3. A structural macro downturn in the area
I call this the “Detroit” scenario. This is where we try to get comfortable with the local industry mix (ideally nicely diversified across sectors), business prospects, and population demographics.
4. Rising interest rates
If inflation comes back to the fore, will we be able to raise rents quickly enough to offset the increase in our mortgage servicing costs? Is there a way for us to hedge this risk with a long-term, fixed-rate mortgage?
Do we have enough of an equity / cash cushion to sustain any near-term hits to our rental income? Sure, the pandemic is top of everyone’s mind today but there are also problem tenants you cannot immediately evict, a commercial space you cannot find a tenant for, etc.
Once you’ve found an investment you really like, answering the questions above may seem like a nuisance. I mean, what are the chances?
And yet, we’ve had multiple situations where we’ve walked away from attractive properties on account of not being able to mitigate significant tail risk.
In retrospect, those were all excellent judgment calls.
However, the most fascinating application of a pre-mortem has nothing to do with money.
Jeff Bezos once gave an interview where he described his regret minimization framework. The three-minute video is worth your time.
Investing failures and regrets are one thing. But what if you were to ask yourself:
“What are the things that could cause my entire life to be a giant disappointment?”
Everyone solves for a different set of parameters in life, and so everyone will have a wildly different set of answers here.
For me, some of the things that come to mind are:
- Failing to build up trusting, quality relationships with our children
- Sacrificing health to make money – only to kick the bucket way before my time
- Rising up to the expectations of others instead of my own
- Being too scared to follow through on my dreams and aspirations
The items that are not on the list can be even more informative, as they often include conventional definitions of success.
Will you really be disappointed if you don’t become rich or famous? And is it really such a big deal if you don’t ever make the C-suite?
Whether it relates to investing or life design more broadly, running a pre-mortem can go a long way in helping make better decisions. No wonder it stuck with me for all these years.
I hope it will come in handy on your own journey as well.
Thank you for reading!
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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