Scenario Analysis can be defined as the process of estimating the futuristic and expected value of the portfolio after the specific fulcrum of time frame. The entire process of the Scenario Analysis assumes the specific changes or alterations in the values of the portfolio’s securities change in the interest rates and the consideration of other market dynamics.
The process of Scenario Analysis is mainly used to estimate the developments in the portfolio’s values in case of any unfavourable events in the market or within the organization and it is also used to examine the theoretical worst case scenario affecting the functioning of the organization or the overall market.
Anatomy of the Scenario Analysis :
The methodology of Scenario Analysis involves computation of the various investment rates for the expected returns that are invested and reinvested within the specific horizon of the investment portfolio.
On the basis of the various statistical and mathematical principles, the process of Scenario Analysis estimates the drift of the value of the overall portfolio on the basis of the occurrence of the different internal and external situation that is termed as the scenarios.
The final assessment arrived after the process of Scenario Analysis; the results can be used to examine the risk factor present in the each of the given investment in relation to the variety of potential events ranging from the highly probable one to the highly improbable one.
The investor is then able to determine and decide if the risk factor falls within his comfort zone or not aftermath the results derived from the overall analysis.
The process of Scenario Analysis can be termed as the technique of calculating the value if the specific investment or the group of investments under the various future possibilities that can work or cannot work in the favor of the investor.
It is the estimation of the expected cash flow and the value of the assets under the various market circumstances with an intention of calculating the risk factor involved.
The scenarios may occur or may not occur, but the investor has to consider even the worst case scenario. The main factor of consideration is that the procedure of Scenario Analysis is not dependent on the results of the past and the historic data works as the framework on the basis of which the future Scenario Analysis is conducted.
Scenario Analysis and Investment Strategy
Of the many different ways to conduct the Scenario Analysis, one of the most common methods is to determine the standard deviation of the daily or monthly investment security returns and then calculate the value expected from the portfolio and if the security generates the returns that are two to three times of the standard deviations above or below the average returns expected.
By stimulating the extreme conditions, the analyst is able to have a reasonable amount of certainty with regards to the change or drift in the value of the investment portfolio in a given fulcrum of time.
The scenarios that are considered related to a single variable such as the success or failure of the newly launched product in the market. Even the combination of factors can be considered such as the launch of the new product in the market along with the developments in the activities of the competitors in the market. The main aim and objective of the analysis are to examine the results of the extreme outcomes to determine the investment strategy.
Scenario Analysis in the stream of Financial Decisions
The similar process of Scenario Analysis is used to examine in the other financial institutions to study the potential investment portfolios and the value shifts based on the theoretical scenarios.
Even on the side of the consumers, they can follow the process of Scenario Analysis to determine the various financial outcomes of purchasing any item on the credit basis as compared to saving the funds for the cash purchase. Even the person the look into the various financial changes and developments that may or may not occur whilst deciding to accept the new job offer
Even in the case of business, the business owners can use the Scenario Analysis to examine the potential financial outcomes based on the specific decisions such as selecting from one of two facilities or business models or storefronts from which the business could operate.
This includes the points of considerations such as the difference in the rent, insurance, utility charges, overheads or any other benefit that exists on the specific location but not on the other location option available.
The purpose of Scenario Analysis :
- Through the process of Scenario Analysis, the investors and business managers can examine and determine the level of risk that they are undertaking before making any crucial investment or staring any new or important project.
- Being one of the structured ways of thinking and analyzing the future, the technique of Scenario Analysis helps to figure out and identify the potential problems in the future. With the thorough analysis, we can take the necessary steps to avoid the problems or reduce their impact on the business or the investment portfolio.
Types of Scenarios in Scenario Analysis :
1) Best Case/ Worst Case Scenario
There are so many times that we realize that the actual outcome of the investment is that we had expected and it is totally different. And this because of our assumptions as we make them based on our predictions. But when we conduct the best case/ worst case Scenario Analysis, we consider multiple assumptions that widen the horizons.
In case of the best case scenario, each and every input value is set for the best assuming that the overall economy and the industry will witness the best growth rate and on the basis of our best assumptions, we determine the best outcome and returns.
On the flip side, when we take the worst case scenario into account, each and every input value is set as worse. And it is concluded that every market and industry factor will work out at its worse and we will have the X or Y amount of returns.
2) Multiple Scenario Analysis
The technique of Scenario Analysis cannot be restricted to only the best and worst case scenarios but most of the investments are predicted considering the multiple case scenarios in question. For example, if the technology giant Apple is launching the new phone in the market and wants to predict its sales than it has to take multiple scenarios into the consideration.
Like, if the industry grows by 10% for example, it will witness X amount of sales or if it dips or grows by 20%, it will witness Y amount of sales. This way multiple outcomes can be analyzed and the company can be more agile and prepared.
Problems with the Scenario Analysis :
1) The success of Scenario Analysis is unpredictable in nature
In the process of Scenario Analysis, to get the facts right, we might do the detailed study of the internal and external factors, make clear assumptions about all the possible scenarios but many a time, the results are not at all the expected ones. Hence, it can be concluded that there are thousands of factors that affect the various situation deferring the expected outcome.
2) Cognitive Bias
In the process of Scenario Analysis, the decision makers consider the multiple scenarios such as best, average, and worst. But it is the human nature and psychology to consider the occurrence of the average scenario the most and get biased to make certain decisions surrounding to the same that can be very dangerous at times.
3) Requires Continuous Improvements
The Scenario Analysis requires continuous and consistent revisions, control, and refinements by the experts or specialized teams. To arrive at the wise decisions and get the optimal and maximum benefit out of the entire procedure, the process of Scenario Analysis needs to be updated at regular intervals.