People are pretty good at identifying goals, whether in investment portfolios, careers or relationships. When we fall short, it is frequently because of trouble keeping our decisions along the way aligned with our original goals.
But there are a pair of time-traveling tools that can help you better follow through on your plans and keep your investments on track: backcasts and premortems.
A backcast is an exercise where you imagine having reached a goal and then you work backward to figure out what happened to get you there. A premortem imagines the opposite — failing to reach your goal — and asks “how did that happen?”
Backcasting is a more instinctive exercise. After all, we generally plan for success.
Imaging failure, on the other hand, doesn’t feel good. But failing to do a premortem can ruin even well-thought-out strategies for long-term success. If we anticipate later actions that can undermine our plans, we can improve the likelihood of staying on course.
To see how a premortem can reveal serious weaknesses in investment strategy, look at the February collapse of several arcane products known as “inverse-VIX ETPs.” The CBOE Volatility Index, or VIX,
measures the anticipated volatility of the stock market over the next 30 days. Because increases in volatility are typically associated with downside moves in stock markets, a product linked to VIX can serve as a hedge for an equity portfolio. There are also products that profit when the VIX goes down. For example, an inverse-VIX product would profit when implied volatility falls, which tends to coincide with positive trending stock markets.
The S&P 500’s
big gains of 2016 and 2017 were accompanied by very little volatility. On most days, VIX remained low or declined. For investors long the market but hedged against an increase in volatility, long-volatility products hurt returns, which is what you would expect when you take out a hedge against something that doesn’t happen.
As an investment strategy, XIV resembled a gambler betting it all in the casino, going on a winning streak and continuing to let it ride.
Meanwhile, inverse-VIX ETPs, which generally move with the direction of the stock market, soared during this period of low-volatility. One of those products, XIV, was worth 20 in February 2016; it climbed to nearly 150 in January 2018 as the VIX sank to new lows.
Then things changed. The stock market’s gyrations at the end of January and early February nearly doubled the level of the VIX, which helped buoy the portfolios of those who hedged their positions. Investors who were short volatility via inverse-VIX instruments, on the other hand, were essentially wiped out, as XIV went from $150 to $6.
As an investment strategy, XIV resembled a gambler betting it all in the casino, going on a winning streak, and continuing to let it ride. Wittingly or unwittingly, XIV investors signed on to the “let it ride” strategy. When the market turned, they lost everything.
The easy lesson is the dangers of greed and overconfidence. Teaching prospective investors to avoid those dangers next time is more difficult. This is where a premortem can be so useful.
A premortem exercise would ask the uncomfortable question before the investment decision: “I went broke investing in XIV. Why did that happen?” The answer would reveal itself: “A major volatility event would drive VIX up 100% in a day, which would make XIV go down 100%.”
In contrast to a premortem, which would clearly reveal the risk of an XIV investment in advance, a backcast might cause you to keep pressing your bets. Consider the following backcast: “I ended up making a ton of money. Why? I kept my money in play, kept winning, and kept pressing my bets.”
You don’t need to be considering something as complex as shorting volatility-futures to use a premortem to identify future risks that can undermine your plans. Consider the basic question of “how diversified should my stock portfolio be?” A backcast may suggest that an investor go all-in on a concentrated basket of small-cap value stocks because this might maximize the expected returns; but a premortem will consider that the portfolio may suffer untenable drawdowns that force the investor to potentially liquidate at the worst possible time. The combination of a backcast and a premortem might lead the investor to own a broad globally diversified stock portfolio.
Backcasting isn’t necessarily bad and premortem analysis isn’t a be-all and end-all. The two strategies complement each other, bringing a more balanced set of scenarios under consideration. The backcast can highlight the path to victory, but the premortem will force you to consider what can go wrong. The dual-pronged process makes it easier to make rational decisions, both initially and when considering whether to alter a goal.
Annie Duke is a world champion poker player and the author of “Thinking in Bets.” Follow her on Twitter @AnnieDuke.