Saturday, May 16, 2020

The big need for scenario analysis during this pandemic


What will happen next quarter, for the rest of the year, or for the next two years? You are not going to find out by forming some expected return or volatility measure based on past data. There is no easy way to compare an unexpected future with the pre-COVID-19 past. There are only uncertain futures given the uniqueness of the "Great Lockdown". That does not mean that the future will behave irrationally, nor does it mean that we have no idea what the future will hold.

Investors need a different way of thinking about what may happen in the future and how we should be prepared for these alternative realities. We are not facing measurable risk in the conventional sense of volatility (standard deviation) but rather uncertainty that can be given probabilities. 

A useful framework for scenario analysis has been outlined by Peter Schwartz in The Art of the Long View: Planning for the Future in an Uncertain World. There are other books on scenario analysis, but this is a good read from a strong expert. 

Scenario analysis is more involved than just developing optimistic, base, and pessimistic scenarios. We will not do the outline justice, but here are some of the simple steps for approach a problem that needs scenario building. 


1. Identify focal issue and or decision - What is the decision you want to make? As stated by Schwartz, begin "from the inside out"? For an investor, it could be thinking through the downside for risky assets, or it could be answering the question of corporate bond risk. Provide scenarios for problems that matter.
2. Key forces in the local environment - List the factors that will influence success or failure for that decision.
3. Driving force - Explore the drivers for those key forces. Try and think of the information that you don't have but wish you did.  
4. Rank by importance and uncertainty - Develop a ranking system for those key drivers. The ranking should be on two levels, those drivers that are most important and those that are most uncertain.  
5. Selecting scenario logics - The logic of scenarios will be driven by the key drivers and the uncertainty that is faced. The focus is on the uncertain drivers of that will impact specific decisions. 
6. Fleshing out the scenarios - There is a narrative that describes how these drivers will work through the real economy or the financial system. Think of this as the flow through system. 
7. Implications - From these scenarios, there is a focus on implications. What will other investors and firm do if the scenario arises? What will be the reaction to these scenarios?
8. Selection of leading indicators and signposts - There should be catalysts or markers that will give you some indication that your scenarios are beginning to play out.

I will say that developing scenarios is harder than some quant work. Imaging a world that does not yet exists is not easy, but even provide a foundation for future empirical work.

See also: 
Pierre Wack and deeper thinking about scenario analysis

Using scenario analysis to help with asset allocation - A simple solution to a complex problem

Scenario Analysis for Systematic Managers? Absolutely.



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