World-class investors improve the quality of their decisions with this technique. So do top CEOs and entrepreneurs. Military leaders use it; so do wedding event planners; so do business executives of all kinds. 

Just about any time a complex scenario with a range of outcomes is involved, which is certainly the case with investing, this technique has value. 

You can use this technique, too, to find more success as an investor and make better life decisions in general. The bigger the decision or the higher the stakes, the more valuable this technique becomes.

This incredibly useful technique is called “The Premortem.” It’s related to the better known “Postmortem,” but comes with a few important twists. 

Postmortem literally means “after death.” In medical scenarios, it is an examination of how a patient died and why. 

The goal of a postmortem is to learn what happened and why it happened — and hopefully to gain knowledge and awareness for better results next time. As the old joke goes, everybody benefits from a postmortem except the patient. 

In business or investing settings, the postmortem is an examination of what went wrong with a project or an investment after it has failed. The goal is the same: To learn the causes of failure and, hopefully, to do better next time. 

The premortem is like a postmortem, but with the following big differences: 

  • The premortem takes place before the investment (or project) has failed.
  • Ideally, it takes place before the investment or project even starts.
  • The premortem is an exercise in imagining what went wrong —
  • And then working backwards to identify potential failure causes.

With a premortem, you imagine that “the patient has died” — that an investment idea crashed and burned or that a project has failed miserably. 

After picturing this worst-case scenario in your mind, you then ask the question: “How did the failure happen?” 

From that point, you create a list of what-went-wrong causes resulting from various failure scenarios. 

And then — because the negative outcome hasn’t actually happened yet, only in your mind — you use this list of “what could go wrong” items to failure-proof your project or your investment, increasing the odds that it will survive and succeed. 

The premortem was popularized as a planning technique by Dr. Gary A. Klein, a specialist in natural decision making and cognitive task analysis. 

The value of the premortem was first shown by a study done in 1989, conducted by researchers at Cornell, the University of Colorado, and the Wharton School. 

The 1989 study showed that “prospective hindsight” — picturing a future scenario and imagining it already occurred — increased the accuracy of reasoning by 30%. 

A dramatic example of the premortem at work took place in 1999, leading up to the year 2000 switchover and the famous “Y2K bug.”

As you may remember, there was a great deal of stress and anxiety over what would happen when computer-based dating systems rolled over from 1999 to the year 2000, because so many systems that stored a year as two digits would go to “00.”

These Y2K fears were so widespread, there was talk of power grids shutting down and planes falling out of the sky. The Federal Reserve even took steps to have extra cash available in ATMs to meet the demands of nervous citizens.

But then a funny thing happened — nothing at all. The year 2000 switchover was a non-event in Y2K terms.

But the reason Y2K was a non-event is because corporations the world over were subjected to a massive premortem.

They were presented with such dire failure scenarios that every major CEO, and the head of every major IT department, was forced to game out the risks of what could go wrong as a result of Y2K, leading to advance preparation that averted the crisis. Intense worry led to the biggest premortem-at-scale exercise the world had ever seen.

The reason the premortem works — imagining things went wrong, then working backwards to detect failure points — is because it forces the brain to exercise dormant creative muscles and break out of normal channels.

With normal prediction or forecasting habits, where someone is asked what they expect to happen around a given investment or project, it is easy to be swayed by all manner of psychological pitfalls: Confirmation bias, extrapolation, overconfidence, and more.

It is also easy to get stuck in a rut — focusing on a handful of “knowns” but not the uncomfortable unknowns — or, if making decisions as a committee, to succumb to “group think” where mutually friendly opinions reinforce each other.

In saying “imagine X has failed, and then work backwards,” the premortem technique takes the brain to a new place. If you genuinely try to imagine failure has already occurred, and then try to work out why, the subconscious will organize its agenda in a different way.

This increases the odds of generating new insights, seeing problems more clearly, or identifying factors that otherwise would have been missed.

The premortem also results in smarter risk management. Sometimes it makes the difference between success or failure, by bringing to light a problem that otherwise could have brought down the whole project.

For example, in a 2007 article for the Harvard Business Review, Gary Klein shared an anecdote about a military air-campaign project involving the use of algorithms.

As part of the premortem exercise, a team member pointed out the laptops being used in the field might not have the computing power to run the algorithms quickly enough — with results taking hours when they would be needed in minutes.

In response to this premortem issue, the algorithm developers implemented a shortcut they were working on. Had the team member not spoken up, the laptop horsepower problem might have been completely overlooked. And if the software had proven too slow in the field, the whole project might have been a bust.

For investors, who have to make similar types of decisions on a regular basis, the premortem technique can fit into a standardized strategy template. A smart investor can use the premortem in at least two ways: To think about what might go wrong with an investment in advance; and to think about what steps they will take, planned out in advance, if a negative investment scenario occurs.

It may sound pessimistic and gloomy to focus on “what can go wrong” in advance. But working through the risks beforehand and having a plan to deal with them is not being pessimistic at all. Instead it raises the odds of success, both for the current investment or project and for all the ones in future.

TradeStops users can build premortem techniques into their investment strategy for superior results. This can be as simple as a list of rules laid out as “if / then” type statements. For example:

  • If investment X hits the TradeStops trailing stop alert, I will automatically sell my shares (or my broker will).
  • If investment X goes into the yellow zone, I will reduce my position size by 50% until it returns to green.
  • If investment X goes into the red zone, I will reduce position size by 90% (or sell completely).

Having a predefined list of rules makes use of the premortem in another interesting way; it anticipates in advance “what could go wrong” with an investor’s own emotional state.

The worst time to prepare for a crisis is smack-dab in the middle of a crisis. When the crisis is occurring, emotions are high and distractions abound, making it hard to think clearly.

Conversely, the best time to prepare for a crisis is well in advance: If you already know what to do, you can execute decisions calmly without having to make new decisions under stress or strain.

It’s a similar story when it comes to investing habits. There is value in conducting a premortem on the pitfalls of one’s own mental and emotional state.

This involves questions like: If this investment goes against me, how will I respond? What are the dangers if my emotions lead me astray? What would that look like and feel like? What rules do I have in place for protection?

Working through these questions, and, for investors, applying a templated set of risk management rules — ideally with software like TradeStops — increases the odds that the rules will be followed when the negative scenario occurs.

This, in turn, preserves capital and increases the odds of success, both medium-term and long-term, as consistently better decisions are made (and rare-but-devastating disaster outcomes are avoided).

Richard Smith
Richard Smith, Ph.D.
CEO & Founder, TradeSmith