Scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes (scenarios).
Principle
The analysis is designed to allow improved decision-making by allowing consideration of outcomes and their implications.
Scenario analysis can also be used to illuminate "wild cards." For example, analysis of the possibility of the earth being struck by a large celestial object (a meteor) suggests that whilst the probability is low, the damage inflicted is so high that the event is much more important (threatening) than the low probability (in any one year) alone would suggest. However, this possibility is usually disregarded by organizations using scenario analysis to develop a strategic plan since it has such overarching repercussions.
Financial applications
For example, in economics and finance, a financial institution might attempt to forecast several possible scenarios for the economy (e.g. rapid growth, moderate growth, slow growth) and it might also attempt to forecast financial market returns (for bonds, stocks and cash) in each of those scenarios. It might consider sub-sets of each of the possibilities. It might further seek to determine correlations and assign probabilities to the scenarios (and sub-sets if any). Then it will be in a position to consider how to distribute assets between asset types (i.e. asset allocation); the institution can also calculate the scenario-weighted expected return (which figure will indicate the overall attractiveness of the financial environment). It may also perform stress testing, using adverse scenarios.
Depending on the complexity of the problem scenario analysis can be a demanding exercise. It can be difficult to foresee what the future holds (e.g. the actual future outcome may be entirely unexpected), i.e. to foresee what the scenarios are, and to assign probabilities to them; and this is true of the general forecasts never mind the implied financial market returns. The outcomes can be modeled mathematically/statistically e.g. taking account of possible variability within single scenarios as well as possible relationships between scenarios. In general, one should take care when assigning probabilities to different scenarios as this could invite a tendency to consider only the scenario with the highest probability [1].
Financial institutions can take the analysis further by relating the asset allocation that the above calculations suggest to the industry or peer group distribution of assets. In so doing the financial institution seeks to control its own business risk rather than the client's risk portfolio.,
Geo-politic applications
In politics or geo-politics, scenario analysis involves modelling the possible alternative paths of a social or political environment and possibly diplomatic and war risks. For example, in the recent Iraq War, the Pentagon certainly had to model alternative possibilities that might arise in the war situation and had to position materiel and troops accordingly. The difficulty of such forecasting is highlighted in that case by the fact that arguably the Pentagon failed to foresee the lawlessness and insecurity of the post-war situation and the level of hostility shown towards the occupying forces.
Traditional Critique
While there is utility in weighting hypotheses and branching potential outcomes from them, reliance on scenario analysis without reporting some parameters of measurement accuracy (standard errors, confidence intervals of estimates, metadata, standardization and coding, weighting for non-response, error in reportage, sample design, case counts, etc.) is a poor second to traditional prediction. Especially in “complex” problems, factors and assumptions do not correlate in lockstep fashion. Once a specific sensitivity is undefined, it may call the entire study into question.
It is faulty logic to think, when arbitrating results, that a better hypothesis will obviate the need for empiricism. In this respect, scenario analysis tries to defer statistical laws (eg., Chebyshev's Law), because the decision rules occur outside a constrained setting. Outcomes are not permitted to “just happen”; rather, they are forced to conform to arbitrary hypotheses ex post, and therefore there is no footing on which to place expected values. In truth, there are no ex ante expected values, only hypotheses, and one is left wondering about the roles of modeling and data decision. In short, comparisons of "scenarios" with outcomes are biased by not deferring to the data; this may be convenient, but it is indefensible.
“Scenario analysis” is no substitute for complete and factual exposure of survey error in economic studies. In traditional prediction, given the data used to model the problem, with a reasoned specification and technique, an analyst can state, within a certain percentage of statistical error, the likelihood of a coefficient being within a certain numerical bound. This exactitude need not come at the expense of very disaggregated statements of hypotheses. R Software, specifically the module “WhatIf,”[2] (in the context, see also Matchit and Zelig) has been developed for causal inference, and to evaluate counterfactuals. These program have fairly sophisticated treatments for determining model dependence, in order to state with precision how sensitive the results are to models not based on empirical evidence.
See also
References
- "Learning from the Future: Competitive Foresight Scenarios", Liam Fahey and Robert M. Randall, Published by John Wiley and Sons, 1997, ISBN 0471303526, Google book
- "Shirt-sleeve approach to long-range plans.", Linneman, Robert E, Kennell, John D.; Harvard Business Review; Mar/Apr77, Vol. 55 Issue 2, p141
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