The Pre-Mortem: A De-Biasing Technique to Increase Trading and Investment Success.


Imagine you had the rare ability to be able to see into the future. How wonderful would it be to be able to know what was going to happen, to make accurate forecasts, to produce prophetical spot-on predictions. A nice thought but sadly one that, in the absence of magical or divine powers, is no more than a pipe-dream. Perhaps the next best thing would be 'Forward hindsight' the ability to say, 'I knew that was going to happen' and to have acted upon that. However, perhaps there is a way to have that rare gift to develop forward hindsight after all!

Extensive research has found that ‘prospective hindsight’ imagining that an event has already occurred—increases the ability to correctly identify reasons for future outcomes by 30%. In my coaching work I encourage people to consider employing a technique called the 'Pre-Mortem'. This technique, invented by the psychologist Gary Klein, is a tool or process which Daniel Kahneman, his Nobel-winning colleague, describes as his favourite method for making better decisions. When doing a 'Pre-Mortem', you imagine yourself in the future, after a project which has failed 'spectacularly'. You then explore the potential reasons for that future failure. 

Whilst this tool was conceived for projects, as a technique I find it can make a huge difference to people's trading and investment performance.

Prospective Hindsight: Helping Overcome the Uncertainty Challenge in Financial Markets.

One of the key rationales for using the ‘Pre-Mortem’ in Financial Market settings, is to bring understanding to complexity, and to limit the negative and unsettling impacts of 'uncertainty'. The following graphic highlights four different type of environments which people find themselves in when faced with challenges.

This model is a simplified adaption of the ‘Cynafin’ model. The top left hand corner describes the environment typically found in financial markets, The 'Complex environment'. The 'Complex environment' is the domain of sensory information, this type of environment is one of heightened uncertainty, rapidly changing condition, and limited information.

Problem solving in this 'Complex environment' requires a particular type of response. However often we engage in problem solving more suited to a 'Complicated environment'. This is section toward the 'top right' corner of the graphic. The complicated environment, is the domain where expertise is required, however it is a fairly static environment, thus as long as the problem is understood by the expert, then they can resolve it. In our society we have been largely conditioned through education and training for  the ‘complicated’ environment, the ‘top right’ hand corner of this graphic. 

Problem solving in the 'Complicated Environment'. 
 

However, this process falls short when practiced in a ‘Complex environment’, with its heightened level of uncertainty and only partial information. In this environment, the process for dealing with problems and challenges is best described as:



It is with this highly uncertain environment of constant re-calibration, changing situations, new news, ongoing events, that people’s ability to respond effectively is highly challenged, and that their biases and human limitations come to the fore.

Pre-Mortem thinking in a ‘trading and investment’ environment.

A pre-mortem process is usually carried out by a team working on a project. All project team members are asked to write down every reason they can think of for the failure. These reasons for failure are then discussed openly.

Although project teams will have engaged in risk analysis, the pre-mortem’s ‘prospective hindsight’ approach offers benefits that other methods don’t. It focuses attention on whether assumptions may be incorrect and raises exploration on concerns which were originally dismissed. This counters some of the thinking which causes people to become over-invested in a project or idea. Additionally, the exercise sensitizes the team to pick up early signs of trouble once the project gets under way. Use of the ‘Pre-Mortem’, has led to spectacular improvements in project success.

Applying the Pre-Mortem to Trading and Investment.

Although Pre-Mortems are a team process used predominantly in projects, one can adopt ‘Pre-Mortem’ thinking to trading and investment settings, both in teams and group, as well as individually. Consider the team meetings which typically occur in an investment bank or hedge fund. How often is an idea or view railroaded through a meeting, often by the loudest voice, most senior individuals, or by a pre-agreed consensus? How often does this come to affect thinking and drive subsequent behaviours and actions? Adopting a ‘Pre-Mortem’ approach to these team meetings could help produce a more thorough robust process which de-biases proceedings, improves the success rate of these meetings and the ideas generated, and enhances the subsequent execution of these ideas.

Additionally, applied to individual trading and investment behaviours and analysis processes, ‘pre-mortem’ thinking can help improve traders and portfolio-managers’ success rate, and help sales-people improve their service to clients and customers. As a coach, I encourage people to try and adopt pre-mortem thinking within aspects of their work, from how they analyse markets, to how they execute their actions, to how they manage their risks and capital.

Countering Behavioural Biases and Limitations.


This is one of my favourite illusions. I often lead with this one on 'Behavioural Finance' seminars and workshops I give. No matter how much I try and tell people that square A and square B are identical colours, no one believes it. And the truth is, that even though I know they are the same colour, they still look different to me. Our brains don't work the way we think they do! - To see this illusion proved and exlained go to http://web.mit.edu/persci/people/adelson/checkershadow_proof.html


Behavioural finance research over the past two decades has provided deep insight into how human behavioural limitations impact people’s abilities to behave and act rationally within trading and investment activities. Behavioural finance experts and economists tend to think of these as flaws in people’s thinking, the ‘Naturalist Decision Making’ school of thought however views these biases and limitations as part of how we operate, rather than necessarily being flaws. Accepting that this is how we ‘work’ allows us to then come up with ways to work better. ‘Pre-Mortem’ thinking is one way to help achieve this’.

The following 2 examples are from clients of mine who have successfully integrated 'Pre-mortem thinking into their working practices, with very powerful results. 

Client A was a Hedge Fund options trader. – He used a quantitative and systematic approach, creating elaborate models, and thoroughly back-testing ideas. His whole process appeared highly automated, yet at the core there was a significant discretionary element. In reviewing his process and trades and looking at examples over many years, a pattern which was becoming clear. He would start to fall ‘in love’ with certain ideas or views to the extent to that this would start to obscure objectivity. Once this happened all subsequent activities were impacted, the trader’s ‘Confirmation Bias’ ensured that he was now always seeking to prove this view and then designing an idea and concept around this. By encouraging the trader to bring ‘Pre-Mortem’ thinking into his working approach, he started to counter this bias. – He would run a ‘Pre-Mortem’ ahead of all stages of his process. He would take the assumption that the idea had failed and left him with a large loss or sub-par outcome. – He then ran a quick check of all possible reasons. – He had constructed a checklist, which he had evolved and was continuing to evolve. – Amongst checklist points was the idea that he had failed because he had over-committed to an idea, and had not tried to ‘disprove this idea’ sufficiently. This process, then led to various subsequent actions; where this process did not destroy the idea, he  actually had a more real and genuine confidence in the idea. – The upshot was a big improvement in trading performance over time. –

This above example applied to an options trader who used a systematic quantitative approach. It may not seem like it is applicable to the rough and tumble, and rapid decision making of the short-term FX trading world, but this could not be further from the truth.

Client B was a short-term trader on the FX desk at a bank. Amongst his issues, ‘Fear of Failure’ and ‘Fear of Missing Out’, were obscuring clarity around his trading and led to an erratic execution process. Though still making money, his performance was adequate rather than outstanding. He felt that the short-term trading requirement of his work limited his room for manoeuvre when it came to planning, and thus at first felt that the pre-mortem approach was not appropriate for him. – Nonetheless he subsequently agreed to try it to help his position management practices, rather than trade execution. – Every evening and every morning he conducted a 5 minute ‘Pre-Mortem’. – The question he asked of himself was:

‘In the subsequent 12 hours his position had been stopped out for a significant loss’, or ‘had moved in the right direction, but he had failed to maintain his positions and thus missed out on a significant profit’ – what caused this?

Using ‘Prospective Hindsight’ he started to become more conscious of what was leading to sub-par decisions over his position management, and started to become more ‘forward-thinking’ in terms of his position management. This lead to significant improvements in p/l. This ‘pre-mortem’ mindset approach has now become a broader part of his approach, even with in his short-term reactionary trading. This has led to  a stunning performance improvement, more than doubling his best ever year in each of the past two years. This trader is one of the ROI examples featured in this article

Pre-Mortem as part of developing the 'Behavioural Edge'. 

A 'Behavioural Edge' is the most powerful edge one can have in trading and investment. It is what separates the superstars of trading from the rest of the field. Our article 'The 10 Behavioural Traits of Highly Successful Traders & Investment Professionals', explores the traits displayed by highly successful traders and portfolio managers which contribute to deeloping a behavioural edge. These traits are remarkably consistent across most of these traders. Amongst these Trait 6) 'Planning, Preparation, Patience and Discipline', and Trait 9) 'Focus on making money, not being right' are both directly supported by the 'Pre-mortem' approach. The pre-mortem approach is a key part of helping to develop one's 'Behavioural edge'. 

Summary

The pre-mortem approach is very different to ‘brainstorming, and ‘risk-analysis’. It is a de-biasing technique, which brings greater robustness and soundness to analysis, risk and money manegement, portfolio management, and idea implementation. I have used the process to help teams and businesses within trading and investment settings with some outstanding outcomes. I encourage individuals, whether they are leaders, risk-takers or salespeople, to bring this approach into their habitual way of being in their work, it can and does make a huge difference. The great South African golfer Gary Player said, ‘Luck is what happens when preparation meets opportunity’, the pre-mortem ensures that when luck meets opportunity, the trader is better prepared for it. 

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