Investing money involves making uncertain predictions about the future, hoping that something outside of your control will occur to make your investment worth more. Before you invest, or while you hold an investment, you can use scenario analysis to learn about what might happen to your investment under certain conditions.
Scenario analysis is the process of calculating and predicting the value of an investment, or group of investments, under a variety of different circumstances, or scenarios. These scenarios can range from very likely to implausible, but still possible. For each scenario, the investor or analyst considers historical data and the chain of events that will cause the factors in that scenario to impact the investment, for better or worse.
Scenario analysis has several purposes. Investors can perform scenario analysis to determine how much risk they're taking before purchasing an investment product. This is why many scenario analyses account for worst-case scenarios, along with more positive and optimistic scenarios. If a scenario analysis shows that the risk is too great, the investment might not be a good one for you. Scenario analysis also predicts what will happen to an investment given natural changes in the economy, allowing investors to be better informed about how these changes will affect them.
Each scenario that a scenario analysis addresses is defined by one or more factors. The factors in a scenario analysis can be almost anything, from interest rates and inflation to unemployment percentages and commodities costs. The factors used in a scenario analysis depend on what the investor wants to know. A scenario analysis might begin with a question such as, what will my retirement account be worth if there is 10 percent inflation, or how much will my stock portfolio be worth if the cost of oil doubles in five years? These questions would focus on the factors of inflation and oil prices, respectively.
Investment analysts use proprietary calculations and computer models to perform scenario analysis for their customers. For a general scenario analysis you can look at an investment's history, noting its high and low points, and determining what brought about its most extreme variations. To perform a scenario analysis of a portfolio, first look at the best- and worst-case prospects for each investment in the portfolio for the factors you choose to use, and calculate a weighted average based each investment's percentage of the portfolio as a whole.
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