Definition: Scenario analysis is a method of predicting future values of portfolio investments based on potential events. In other words, it’s a method of estimating what will happen to portfolio values if a specific event happens or doesn’t happen. If this happens, then what?
What Does Scenario Analysis Mean?
This process is also used in company operations outside of the investment world. Most managers perform scenario analysis in their business decision-making process to determine the best course of action to take for the organization to maximize profits (best-case scenario). They also use this technique to examine the worst possible solution (worst-case scenario) and anticipate potential losses and operational problems. Management also use this process when launching a new product to avoid cannibalization of existing product sales.
Alternatively, finance managers and analysts use scenario analysis to estimate the expected portfolio value, assuming changes in the interest rates or downturns in the economy.
You can also use this to investigate if your current financial state could support the purchase of a new house.
Let’s look at an example.
Maria wants to create a budget, but she is unsure of her income. By using scenario analysis, she will be able to determine different possible income values and then, perform probability analysis. The worst-case scenario for Maria is a gross income of $70,000 and a cost of goods sold amounting to $35,200. This leaves Maria with a gross profit of $34,800.
The best-case scenario for Maria is a gross income of $120,000 and a cost of goods sold amounting to $28,000. This would leave Maria with a gross profit of $92,000.
In order to compare the two scenarios, Maria creates a scenario report, which summarizes the two options.
Looking at an investment example, let’s assume that Jacob is a financial analyst in a prominent investment firm. He uses scenario analysis to determine different reinvestment rates of the portfolio’s expected returns considering the worst-case and best-case scenarios. For example, interest rates going up 2 points might be the best case and interest rates going down 5 points might be the worst case. He can then give a probability to each outcome and see the investment risk spread. Based on the risk Jacob is willing to accept, he can make his investment decisions.