What is a premortem?
We’re all familiar with the concept of a postmortem. Essentially, a postmortem analyses events after they occur. Postmortems are excellent teachers – they highlight what went wrong and why. So, they fill us with food for thought and ensure that we don’t repeat mistakes. However, some decisions we get to make only once in our life – and there’s no room to get them wrong. For instance, you can retire only once. You have no choice but to get your decision right. Something as complex as retirement requires several decisions to be made over a long period of time. A postmortem on a retirement decision is of no help. What’s the alternative?
A premortem is far more effective. Premortems project various outcomes from a decision. It’s better to ask what happens if I don’t save towards retirement for the next ten years rather than how much would I have today if I started ten years back. Premortems are potent, perceptive, and practical.
The premortem process asks the following questions:
- Is this decision relevant?
- What are the risks involved? What could go wrong?
- How can I safeguard against these risks?
- What are the potential benefits? What is the expected outcome?
- Is there a better way to get these benefits?
Financial Decisions
Premortems are integral to financial decisions. Often, financial choices have a ripple effect. Let’s take Seetha’s case. She is in her mid-twenties with a promising career and looking to settle down. To her, buying a house kills two birds with one stone – it puts a roof over her head and showcases her financial stability. This big decision will play a crucial role in her financial future.
So, let’s do a premortem of Seetha’s decision to buy a house.
1. Relevance
As far as relevance goes, it’s natural to think about settling down. In our society, owning a house is a status symbol. Brainstorming is essential and Seetha must evaluate her options. This will give her the clarity to act.
2. Risks involved
- Financial, personal, and professional inflexibility
- Being unable to service the home loan
- Unclear Exit Strategy
- Unable to save money
- The house becomes an underutilized asset
- House loses value
- The house doesn’t fit her needs
If Seetha services the home loan, she may be anchored to her job. Her career choices will be dictated by her financial position. More importantly, being rooted to the house may even limit her choice of partner. Alternatively, Seetha risks turning her life’s savings into an idle asset that she will not enjoy. Seetha’s dream house may be well beyond her means. This purchase could deplete her accumulated savings and severely restrict her potential to save further. In the event of financial emergencies, she may struggle to find liquidity.
Over time, Seetha may discover that she’s unable to spend money on travelling and must cut back on her lifestyle so that she can afford her house. As her career and marriage progress, Seetha may dream of moving to a better location or bigger house. So, she risks outgrowing her house. Seetha’s exit strategy is also uncertain. Real estate markets work in cycles and she may find it difficult to sell the house at an attractive price. Renting it out doesn’t seem too lucrative, as the potential rent she could earn won’t even cover her EMI outflow.
3. Risk Management
There are several scenarios that could unfold with Seetha’s decision to buy the house. So, let’s address each risk:
– Liquidity Risk:
Any real estate decision is capital intensive. Seetha must ensure that she has enough funds to pay for the house without compromising her ability to service the loan or save for the future. The precondition to Seetha signing on the dotted line is a robust emergency fund. This will provide a liquidity cushion against financial uncertainties – like changing jobs. Consequently, the budget for the house could reduce drastically. She should be conscious that converting her savings into real estate may happen quickly but liquidating her house could take longer. With the right expectations, risks can be effectively managed.
– Needs versus Wants:
Personal finance boils down to striking the balance between needs and wants. Seetha doesn’t need a house right now, but it is something she wants. Spending money on vacations, clothes, and accessories are discretionary. Seetha must decide what matters more and what she’s willing to forego. This establishes priorities.
– Flexibility:
There is no doubt that the house will tie Seetha down. So, it makes sense for her to address the other big decisions first. Seetha should decide her career path and be tuned into her options. Only after she finds a partner should she venture into the process of buying a house. A few years into her marriage, she may have more clarity on their family structure and would be able to pick a suitable house.
– Procrastination:
The sheer volume of things to consider before buying a house could overwhelm Seetha. To prevent inaction, she should set timelines. Breaking down the decision into smaller tasks reduces complexity. For instance, she could set targets for the down payment, emergency fund, and career trajectory. The timelines will measure progress.
– Benefits & Outcomes:
Clearly having an asset to one’s name is a benefit. Seetha could be a proud homeowner in her twenties. Seetha expects to gain social status and become successful through this decision. If Seetha has the financial bandwidth to service the loan without compromising on her other financial needs, there is no debate. However, if the loan will keep her up at night, Seetha would be perfectly right in prioritizing her peace of mind. Sometimes, delaying gratification and avoiding social validation makes financial sense.
Strategic Decision Making
The most important lesson a premortem can teach us is that decision making must be strategic. With this premortem, we were able to anticipate the challenges and consequences that Seetha would face. From this, she can easily decide what kind of consequences are acceptable and what kinds of challenges are surmountable.
Financial Planning Process
The process of planning involves a detailed analysis of the outcomes. A planner can help Seetha prioritize her goals, differentiate between her wants and needs, and identify timelines. A plan can also project Seetha’s financial wellbeing across different choices. So, this will allow her to evaluate whether she should reduce her budget, delay the house, or go ahead with the purchase. A plan doesn’t deliver bad news – it delivers practical solutions. With a planned approach, there’s a clear power shift that puts Seetha in charge. And isn’t that what we all want?