Scenario Analysis Explained

Key Takeaways

• Scenario analysis is often employed to estimate alterations to a portfolio’s value following an unfavorable occurrence and may be used to assess a theoretical worst-case situation.

• Stress testing, a scenario analysis type that specifically considers worst-case scenarios, is commonly employed using a computerized simulation technique to gauge the resilience of investment holdings and institutions against possible future scenarios. 

• Scenario analysis permits managers to test strategic proposals, for example, and to assess how they would turn out under varying conditions.

What if there were a technique that allowed investors to determine whether a negative event has impacted their portfolio’s value, or what might happen to their holdings if the worst comes true? As it turns out, there is. It is called “scenario analysis.” Here it is explained. 

What is Scenario Analysis?

With this process, investors can estimate a portfolio’s expected value after a given period during which changes in portfolio securities are assumed, or after occurrences such as an interest rate change.

In other words, the strategy is often employed to estimate alterations to a portfolio’s value following an unfavorable occurrence and may be used to assess a theoretical worst-case situation.

In addition to an investment strategy, scenario analysis is also used with corporate finance.

How Does Scenario Analysis Work?

With this technique, varying reinvestment rates are computed for anticipated returns that are then reinvested.

Scenario analysis is based on statistical and mathematical principles and provides a way to estimate portfolio value changes due to possible occurrences, or “scenarios.” 

Such analyses also follow the principles of sensitivity analysis, which is how a dependent variable is affected by the different values of an independent variable.

Scenario analysis can be employed to determine the level of investment risk for a range of potential events. An investor can use analysis results to determine whether the risk level is acceptable.  

A common approach in scenario analysis calls for determining daily or monthly security returns’ standard deviation. That is followed by computing the portfolio’s expected value if each security yields returns that are two to three standard deviations over and under the average return. In simulating such extremes, an analyst can be reasonably certain of a portfolio’s value change during a given period.

Scenarios under consideration can be related to a sole variable – a new product launch, for example – or multiple factors, such as product launch results combined with prospective changes in a competitor’s business activities. The aim is to assess extreme outcome results to establish the investment strategy.   

Companies can also employ scenario analysis to help them make decisions regarding, for example, the facility they should buy for operations. Considerations could include differences in rent, insurance, utility fees, or any advantage that favors one location over the other.

Managers can use scenario analysis for almost any decision, especially those having to do with competitive strategy. In other words, the strategy permits managers to test strategic proposals and assess how they would turn out under varying conditions.

Companies can use the tool to study the varying prospective impact of unfavorable and favorable events, including:

• The effect of an economic slowdown on a business’s profitability and revenue.
• The effect of an increase in the cost of new materials on revenue and profitability.
• The effect of a new product line on various revenues.
• The effect on the business of the unanticipated market entry of new rivals.

Note that consumers can also use scenario analysis to assess the varying outcomes of using credit for a purchase, rather than saving the funds to purchase the item with cash. They can also use it to consider possible financial changes that might occur when mulling a job offer.

Examples of Scenario Analysis

Stress testing, a scenario analysis type that specifically considers worst-case scenarios, is commonly employed using a computerized simulation technique to gauge the resilience of investment holdings and institutions against possible future scenarios. 

The financial industry frequently uses such testing to help assess investment risk and asset adequacy, and to gauge internal processes and controls. Regulators in recent years have required stress tests to make certain that capital holdings and other assets are sufficient.

Cases in Scenario Analysis

There are at least three scenario types:

1. Base case. This is a baseline scenario that is based on existing, commonly accepted assumptions.
2. Best case. This is the optimal projected scenario to achieve goals.
3. Worst case. This is the most unfavorable set of assumptions.

Say there is a company called ABC Inc. that produces carpenter tools. It has an idea for a new tool that can not only help sharpen iron but can clean itself afterward. The rub is that it will take around a year to bring the tool to market, and financial analysts are expecting economic headwinds during that period.

Such conditions can impact varying factors, from consumer demand to the prices of raw materials.  The company could consider several scenarios, each one producing different assumptions.

In the best-case scenario, ABC Inc. could experience rising revenues because more people are at home and using DIY methods. In the worst case, demand drops while costs rise across the board. With a base case, existing trends continue. 

Sensitivity Analysis vs Scenario Analysis

While sensitivity analysis is a type of scenario analysis, there are differences between the two. The former gauges the effect of changing only one variable at a time. While scenario analysis considers a broad range of potential outcomes, it assesses the impact of manipulating all variables simultaneously

Benefits and Challenges of Scenario Analysis

The primary benefit of scenario analysis is that it results in an extensive assessment of all potential outcomes, which permits analysts to test decisions, identify prospective risks, and grasp the potential effect of certain variables.

It’s also an educational tool for business partners, improves scenario analysis efficiency, and helps with the cross-checking of model integrity.

In terms of challenges, the chief issue is that false assumptions can result in models that are far off the mark. There is also the potential for user bias and for scenario analysis to be significantly dependent on historical data.

Scenario Analysis and Alternative Investments

Among investors, scenario analysis is more applicable to those with positions in the stock market, since investors can use it to find a portfolio’s likely value following assumed changes or occurrences such as a change in interest rate.

A big part of the allure of alternative investments is that they have low correlation to public markets, and thus are less subject to constant market fluctuations or economic instability, for that matter.  Such asset classes include art, real estate, transportation and more – the alternative investment platform Yieldstreet has the broadest selection available – and can provide consistent secondary income. 

In addition to shielding against inflation and potentially providing steady returns, alternative investments also serve another crucial purpose – diversification. Creating a portfolio of varying asset types and expected performances can mitigate overall performance risk, which is key to long-term investing success. 

Alternative Investments and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

As a tool, scenario analysis can be very useful for investors and managers in terms of navigating future uncertainty. It provides a way to analyze the future in a structured and rational manner. However, it is only as effective as user inputs and assumptions.