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What Is Scenario Analysis?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 04 July 2014
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Also known as a horizon analysis or a total return analysis, a scenario analysis is a strategy that involves the assessment of various potential future events and the development of scenarios regarding what would likely come to pass if various combinations of those events did take place. This process is helpful in a number of situations, including business expansion and investing. Individuals and businesses alike can benefit from engaging in this type of analysis.

For a business, scenario analysis is very helpful when it comes to making plans for launching a new product or cultivating a new market of consumers. By identifying various factors that could have an impact on the success of the project, it is possible to begin creating scenarios that can help project what could happen if certain factors were addressed in specific ways. The exercise can often lead to anticipating and resolving issues before they ever have the chance to undermine the project, thus enhancing the chances for success.

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Investors can also make use of scenario analysis when considering various types of investment transactions. For example, considering what would happen to the value of a given stock if key officers left the company issuing the options, natural disasters, or even political changes may influence the investor’s course of action. If the scenarios indicate that events with a high probability of occurring will cause the shares to increase in value, while also indicating that less likely events would have minimal impact on the stock, there is a good chance that the investor will move forward with the purchase.

The process of scenario analysis can be used for short-term projects as well as long-term situations. Investors who are seeking a quick return on an investment can utilize the strategy just as efficiently as someone who is looking for ways to build a financial portfolio that will generate a modest but consistent return over the years, thus creating a nest egg for retirement. The key to making the strategy effective is making sure to consider all variables that can be reasonably identified and follow each of the resulting scenarios to their likely conclusion. Once that has taken place, it is possible to make an informed position in terms of how to proceed.

As with many types of financial strategies, the value of scenario analysis is only as good as the information that goes into the process. Failing to take into account certain probable events increases the risk of making poor decisions, and ultimately losing money or other resources as a result of the course chosen. At the same time, pursuing scenario analysis with a great deal of verifiable detail can help make it possible to accurately project future market yields, increase profits, and make the total returns from the project higher than they would have been otherwise.

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Discuss this Article

ZipLine
Post 3

I'm not sure how useful scenario analyses truly are. They are just predictions so their usefulness depends on how right the predictions are.

But the economy is not predictable. It's very difficult to guess what might happen in the near or distant future. It's great to be prepared for the worst, but more than likely, things will not turn out as predicted.

ysmina
Post 2

@bluedolphin-- Absolutely. Businesses who want to reduce risks and who want to prepare for the worst-case scenario will definitely engage in scenario analyses to understand what might happen. Most investors do this even if they're not diversifying.

Businesses usually have several scenario analyses for various situations actually. First of all, businesses may prepare and consider scenario analysis about the general condition of the economy. They might prepare scenarios about economic growth or market growth rates to get an idea of what profits and losses may be like in upcoming periods or years.

If a business is investing in new sectors, then it will also want to consider scenario analyses about stocks or bonds and how profitable they will be.

bluedolphin
Post 1

Do businesses look at scenario analysis before they diversify? Meaning before a business starts producing an additional and different good, do they use scenario analysis to try to figure out whether things will work out?

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