We often hear from clients: “What is the difference between scenario planning and forecasting?” Why do we prefer scenario planning at SFG? Scenario planning sits at the heart of our risk management process and philosophy. The official definition of scenario planning is: “The process of visualizing what future conditions or events are probable, what their consequences or effects would be like, and how to respond to, or benefit from them.” As you can see, scenario planning takes into consideration past events, as well as events that we are currently monitoring as probable disruptions.
A scenario example that we are working on is: As government debt grows globally, what would be the economic implications if the United States government defaulted on their debt? Historically the U.S has never defaulted on its debt; however, as the debt moves higher, the threat of this event grows larger. This is where scenario planning comes into play. One solution the U.S has to avoid this situation is through printing its own money and deflating the U.S dollar. So one possible outcome under this scenario may be where we experience inflation and/or are downgraded in credit quality. This event could cause a correction in the equity markets, while Treasury yields could spike and possibly have a negative effect on U.S GDP growth. The implications of a downgrade would not be contained to domestic markets, but rather have an international impact. China and Japan are two of the largest foreign holders of U.S. Treasuries. A downgrade in U.S. credit quality would cause bond prices to fall as investors demand a higher risk premium, which would deplete the value of both Japan’s and China’s reserves.
A historical scenario that we reference quite often is the 2008 Financial Crisis. Using this scenario, we can reference what the economic environment was like, as well as the draw-downs that the markets experienced, and build out a scenario where our portfolios would be if exposed to similar draw-downs but in today’s environment. History never repeats itself but it does rhyme which is why it is just as important to look back at history as it is to look toward the future.
The strength of using scenario planning is that it is a mix of qualitative (fiscal policy, geopolitical tensions, etc.) and quantitative (GDP, unemployment, etc.) views when approaching risk management. This allows for a top-down/bottom-up approach, as well as looking forward to the future and seeing how a portfolio might react to certain market situations. We believe this makes scenario planning much less rigid than traditional forecasting methods.
Forecasting deploys historical quantitative methods. These methods predict what will happen in the future by relying mainly on data from the past and present. This leads to a very rigid risk management assessment. These models often fail to predict quick and significant changes in market conditions. A weak spot when using forecasting to assess risk is that in dynamic market conditions, these models often break down because they are experiencing new events that are not modeled in their test statistics.
We believe scenario planning to be far superior and more strategic than traditional forecasting methods. Scenario planning offers a greater level of flexibility and preparedness than purely quantitative forecasting models. Because we manage money for the long-term, building around scenarios allows us to react and not predict regarding these black swan events, and gives us the ability to help assess risk measures at the individual client level.