Are you riding high now that the markets returned 16 percent, 32 percent and 13.5 percent for the last three years? Do you enjoy watching your stock investments go up? Does this motivate you to pour money into the markets?
If you answered yes to those questions, you may be in for trouble. Markets are cyclical — they go up and down periodically. The smartest investors choose a responsible asset investing plan and stick with it through thick and thin. These steadfast investors understand market history, are prepared for the inevitable drops and don’t get overly enthusiastic with the peaks.
There are many investors whose decisions in the stock market are driven more by emotion than reason. Vanguard has several studies that mention this unfortunate reality. If you’re one of those people who become terrified after a market drop and sell near the bottom, this article is for you. The simple premortem investing strategy might keep you from making a big mistake the next time an investing decline happens.
Jason Zweig introduced me to the premortem concept in his recent Wall Street Journal MoneyBeat column, “Reassess Your Investments Before Next Panic.” He referenced Gary Klein, cognitive psychologist, senior scientist at MacroCognition and author of “Seeing What Others Don’t: The Remarkable Ways We Gain Insights.” Since learning of the premortem, I can’t stop thinking about how this simple technique might save investors tens of thousands of dollars or more.
What is the premortem? According to an article by Klein in the Harvard Business Review, a premortem is the opposite of a postmortem. “A premortem in a business setting comes at the beginning of a project rather than the end, so that the project can be improved rather than autopsied.”
The premortem assumes that the patient has already died. In investing terms, the starting point for a premortem is assuming that the market has gone through a large drop, maybe a decline of 25 percent to 40 percent. You take the market failure as a given. The next step is to hypothesize what may have caused the decline. Here’s where you use your knowledge of past market declines, history and your imagination to try and figure out what might cause the stock market to tank.
Here’s a few ideas from my premortem:
1. California has a huge earthquake, devastating the West Coast.
2. The U.S. undergoes a major terror attack.
3. There is a pandemic across the country.
4. China’s financial problems expand causing great financial problems for Asia and the U.S.
5. There are international stock market breaches that impact world markets.
Think of potential scenarios that might have a devastating impact on stock market prices. Consider systematic or market risk factors will impact all stocks on the market, not just those in a certain sector. Systematic risk can’t be diversified away, nor can it be predicted.
How does a premortem help investors? First off, a premortem gets investors thinking about “what if” scenarios instead of getting caught up in the frenzy of a bull stock market. It may increase your awareness of pending circumstances that may be percolating in the economy and could potentially lead to a stock drop.
If you create a worst-case scenario and then consider what may cause it, you can be more rational in your investing approach. If you’re riding out the previous China boom and waiting for a rebound in your SPDR S&P China ETF (ticker: GXC), maybe you’ll decide to sell now and cut your losses. After going through a premortem, you may realize that you’ve allowed the stock portion of your portfolio become too great a proportion of your total allocation. The premortem may cause you to rebalance your assets to a more rational allocation.
The investing takeaway. We’re emotional beings and need to fight against our tendencies toward greed and fear. To avoid behavioral finance missteps, the premortem may be just the tool to inject a dose of rationality into your investment portfolio.
Don’t avoid thinking about worst-case scenarios. With some planning and forethought, you can save yourself from selling low and buying high.
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Take an Investing Premortem Now to Guard Against Bad Decisions Later originally appeared on usnews.com