Scenario analysis
Changing a coherent set of inputs together to describe a recognisable state of the world, such as a recession. It captures risks arriving together, which one-at-a-time testing misses.
Where you will meet it
Scenario analysis appears in 9 learning outcomes on the CFA syllabus. A few of them:
- Value a share by weighting several scenarios by their probabilities
“Scenario analysis builds several internally consistent cases, typically base, bull and bear, each with its own revenue, margin and investment assumptions, values the share under each, and weights the values by their estimated probabilities.”
- Explain how behavioural biases distort analysts' forecasts and ways to offset them
“Overconfidence produces ranges that are too narrow; the remedy is to keep a record of past forecasts against outcomes and to use scenario analysis.”
- Explain geopolitical risk and how it bears on investments
“Analysts generally handle it through scenario analysis rather than a probability distribution, and through avoiding concentrations of exposure that a single political event could impair at once.”
- Assess and interpret an analysis based on historical scenarios
“Historical scenario analysis examines how a strategy or portfolio behaved in particular past regimes, such as recessions, inflation shocks, rising-rate periods or crises, rather than over the whole sample.”
Practise it
Practise scenario analysis until it is automatic: questions that explain every wrong option.
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