Scenario analysis

Scenario analysis is a process that uses certain criteria to determine the possible outcomes of various events. Scenario analysis basically poses a series of "what if" questions designed to determine results when certain circumstances present themselves. People often use scenario analysis to help them make decisions. For example, before investing in a product, a business, or a stock, an analyst might use scenario analysis to determine the risk involved in that investment based on factors such as interest rates or market conditions. In many cases, analysts develop three scenarios—base-case scenario, best-case scenario, and worst-case scenario—when performing a scenario analysis. Debate has surrounded the origin of scenario analysis, but many theorists consider futurist Herman Kahn the founder of the process.

Background

Scenario analysis is believed to have its roots with American futurist and thinker Herman Kahn. A futurist is a person who uses current trends to determine how future events are likely to unfold. In the 1940s, while pursuing his doctorate, Kahn began working for the RAND Corporation. During the 1950s, much of his work focused on military strategies and the likelihood and consequences of nuclear war. His work during this period introduced the concept of scenarios into planning exercises. His 1960 book On Thermonuclear War made him a household name. In it, Kahn supported nuclear arms control and efforts to negotiate disarmament but argued that the United States had to be ready to fight back if attacked. As a result of his work, Kahn earned a reputation for thinking about the "unthinkable."

In 1961, Kahn cofounded the Hudson Institute, an American think tank. In its early days, much of the Hudson Institute's work focused on scenario planning exercises, which were among the earliest forms of scenario analysis. In an obituary in the New York Times following his death in 1983, Kahn was quoted as saying, "We draw scenarios and try to cope with history before it happens." This sentiment underpins the basic concept of scenario analysis.

In Kahn's view, scenarios represented possible events that could arise as a result of a particular process or decision. They helped determine, step by step, how one event or outcome could occur. Moreover, they aided in identifying alternatives at each step that could forward, stop, or reroute the process.

In the late 1960s and throughout the 1970s, strategic planners continued to use and refine scenario analysis. Analysts employed the process in fields such as urban planning and business. In the twenty-first century, scenario analysis is commonplace in the world of business and finance. For example, investors often use scenario analysis to help them determine how much risk is involved in certain investments or how factors such as interest rates or employment trends might influence future sales of a product. People can use scenario analysis in everyday life, too. For example, a person can use scenario analysis to determine whether he should use a credit card to make a purchase now or save up the cash and make the purchase at a later date.

Overview

When conducting a scenario analysis, the first step a person should take is to define the problem or make a plan. In other words, they should identify the ultimate goal of their analysis. For example, an investor might want to determine whether XYZ Stock is a good investment. A renter might want to determine whether she should plan to buy a house within the next six months. A student might want to figure out which college will give him the best education for the best price.

After defining a problem or making a plan, the next step is to gather data. At this point, a person should identify any issues that could affect their goal or plan at any point in the process. These issues may include favorable or unfavorable events or trends. Based on these data, the person can usually identify the key factors that are most likely to influence the outcome of their plan and make certain assumptions about those factors.

Next, the person should divide their assumptions into certainties and uncertainties. In most cases, a person using scenario analysis can be fairly confident about how certain assumptions will unfold over time. Assumptions the person feels confident about can be considered certainties. Those the person feels less confident about are considered uncertainties. Uncertainties are not necessarily negative. They may have a positive or negative effect on the outcome or no effect at all. The purpose of scenario analysis is to figure out what, if any, effect these uncertainties could have on the overall goal or plan.

The last step is to develop the scenarios. A person can develop as many scenarios as they want; however, developing too few scenarios can result in a skewed outlook, and developing too many can make it difficult to reach a decision on how to proceed. A common approach, especially in business, is to develop three scenarios. The first is called the base-case scenario. The base-case scenario is basically an average. Analysts develop it using their knowledge of what they expect to happen. The second is called the best-case scenario. Analysts develop the best-case scenario based on the idea that every step in the process of reaching the goal or carrying out the plan goes better than expected. Although the best-case scenario represents a positive outlook, it should not be based on unrealistic expectations. The third type of scenario is the worst-case scenario. Analysts develop the worst-case scenario based on the notion that everything that could go wrong does go wrong. Like the best-case scenario, the worst-case scenario should not be based on unrealistically low expectations.

Scenario analysis has both advantages and drawbacks. On one hand, it can help businesses or people plan for the future and identify potential risks. As a result, they can be prepared for potential problems if they arise and have a faster and more flexible response to changing conditions. Scenario analysis also can prevent businesses or people from making poor decisions. On the other hand, scenario analysis can get unwieldy and be very time-consuming, especially as the number of factors to consider increases. It can account only for anticipated risks, so if an analyst fails to recognize a risk, it will not be factored into the analysis. In addition, although scenarios can identify probable outcomes, they cannot actually predict what will happen. No scenario is more likely to occur than any other.

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