Scenario Analysis - Explained
What is Scenario Analysis?
Written by J. Mance Gordon
Updated at April 19th, 2024
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What is Scenario Analysis?
Scenario analysis is a technique used in the analysis of future events by taking other possible outcomes and events into consideration. This analysis can be used in the financial markets to evaluate decisions by considering other alternatives or possible outcomes. It is important to know that scenario analysis is not used to project a particular future outcome or event, rather, it gives projection into possible future outcomes. In the investment market, scenario analysis is used to estimate the expected return of an investment portfolio after a specified time, this analysis takes into consideration changes that occur to the securities in the portfolio.
How is Scenario Analysis Used?
Analysts often use scenario analysis approach when they want to estimate the expected value of a portfolio when unfavorable changes occur in the market. This technique helps to project or predict the possible responses of the portfolio, especially in the worst cases. Hence, for an analyst to estimate the expected rate of return of a portfolio, different expected returns the portfolio is likely to attract must be considered. Aside from projecting the return of a portfolio, scenario analysis can also help to examine the risks in an investment portfolio, given certain events. Market analysts specifically estimate the expected returns of an investment portfolio using the worst-case scenarios. The important points you should know about scenario analysis are;
- Scenario analysis is a process of estimating the expected (future) return of an investment portfolio based on certain events and changes in the market.
- This form of analysis takes into consideration all expected returns for the portfolio in the worst-case scenarios.
- Scenario analysis is not only used to estimate most likely occurrences and outcomes, but it can also be used for the most unlikely events.
There are diverse ways scenario analysis is used when making decisions as to which investment strategy is the best to use. Some analysts just use scenario analysis to estimate the likely returns of investment while some discover the underlying risk of investment through scenario analysis.