Scenario Analysis
“Scenario analysis” might sound like a really complicated and complex concept, but at its core, it’s really not. We’ve all been scenario analysts at some point in our lives.
So...what is it? It’s looking at a specific situation, or scenario, and evaluating all the different ways it could play out in the future. We’re trying to gauge the risks associated with something.
Like...let’s say we live in Seattle but just received a sweet job offer in Denver. Before we say yes or no, there’s a good chance we’re going to give some thought as to how our decision will affect us—and our family and friends—now and into the future. It’s basically us saying things like, “If Uncle Rick’s cancer takes a turn for the worse, we’re going to wish we hadn’t left Seattle,” or, “If real estate values in Denver continue to climb like they have been, we could make quite a bit of money buying a house there now and selling it in a few years.” Then we take those if-then statements and decide how probable the event is and how much it would impact us, and we use that to guide our decisions.
In the business universe, scenario analyses tend to involve a lot of calculations, models, tests, and computations, but at the end of the day, they’re trying to answer the same question we are: what’s going to happen in the future with this thing we’re looking at? Maybe that thing is a mutual fund’s expected performance. Maybe it’s a geographic real estate market. Maybe it’s an R&D project in our organization. We’re just trying to look at all the possible variables and outcomes that could arise in a particular situation and decide (a) how likely or unlikely they are to occur, and (b) what kind of effect they would have on the situation as a whole.
For example, if we take that job in Denver and the city is leveled by an asteroid one month later, that would be quite catastrophic, and would definitely have a big impact on our employment and living situation. But it’s also super unlikely to occur, so it’s probably not something we’re going to worry too much about.
