How To Reduce Your Investing Errors in One Single Step

In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.”

— Swedish Economist Erik Falkenstein

When it comes to investing, there will be times when we commit an unforced error. As Swedish economist Erik Falkenstein would put it: If we are starting out in investing, we should think about ways to reduce our investing errors. With that in mind, I would like to share one approach today, and it comes with some help from Michael Mauboussin, the Head of Global Financial Strategies at the Swiss bank Credit Suisse.

Having a pre-mortem

In an interview with the Motley Fool’s Chief Executive Officer, Tom Gardner, Mauboussin shared an excerpt about reducing errors called the “pre-mortem”:

A pre-mortem, and this idea, by the way, was developed by a social psychologist named Gary Klein. He has a very different concept. He says before we actually make the decisions, so we’ve not put any money to work yet. Let’s launch ourselves into the future, and let’s just say a year from now. Let’s say that we made the investment and it turned out badly. Now each of us independently should write down on a piece of paper, or maybe even write a little article about what went wrong. And it turns out when people go through that exercise, they are able to identify up to 30% more factors or variables than they would just standing in the present looking to the future.

Most private investors might be familiar with with the term “post-mortem”. In a post-mortem, an investing mistake has already happened and the investor would try to take lessons from it. In a play off the word “post-mortem”, the “pre-mortem” sets the stage for the Foolish investor to think about what could go wrong with a company before he or she buys the company’s shares.

While it may come across as just semantics and nothing else, Mauboussin points out that this process can in fact help us to find blinds spots in our own investing thesis before we set out to buy shares of a chosen company.

Take the high-flying diamond manufacturing systems maker Sarine Technology Ltd (SGX: U77) for instance (you can read more about the company here). Shares of Sarine have been on a tear of late, up almost 46% year-to-date (up till 4 December 2014). This stupendous performance towers over the 4% year-to-date returns for the SPDR STI ETF (SGX: ES3), a proxy for the market barometer, the Straits Times Index (SGX: ^STI). Despite Sarine’s jaw-dropping share price performance, the disciplined investor’s interest may be best served with a more sober “pre-mortem” assessment of possible risks in this company.

Through a “pre-mortem”, the astute investor may note that Sarine’s customers are highly concentrated geographically, and that there is a potential industry decline for diamond production in the future. These risks may or may not come to pass, but by identifying potential problem areas, we can better size our investment positions with Sarine to cater for the possible permanent loss of capital. Or, we can also seek a higher margin of safety.

Foolish take away

Simply said, no company is free from risks. If we can get better at identifying risks, we can reduce the number of errors we commit and thus stand a better chance at improving our returns. Our investment portfolios may thank us in the future if we do it well. Learn more about reducing your investing errors through a free subscription to Take Stock Singapore. Sign up here to The Motley Fool’s weekly investing newsletter that will teach you how to grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.