Don't be the crash dummy for your long-term investment strategy

Patricia Pascuzzo explores the many benefits of using 'strategic conversation' and scenario analysis to develop successful portfolio strategies.

Using the art of ‘strategic conversation’ to develop successful portfolio strategies

Slow motion footage of the crash dummy thrusting forward into the steering wheel leaves us all with a sense of ‘glad that’s not me’. With the experience of the financial crisis still fresh in recent memory and with the ongoing market turmoil, we have a heightened recognition of the importance of using tools and techniques to draw out and better anticipate the complexity and origin of multidimensional risk.

Scenario analysis, and the powerful process of strategic conversations among colleagues and stakeholders that it engenders, can be highly effective in developing credible and realistic crash test simulations of investment strategies. Equipped with new insights, these conversations can yield a clearer line of sight for navigating extreme and volatile environments.

Early identification and mitigation of creeping failures that emerge slowly over long periods of time is an important priority for portfolio managers. These represent some of the biggest risks facing global markets as their potentially enormous impacts and long-term implications can be vastly underestimated.

Where there is risk there is opportunity. By challenging status quo perspectives, scenario analysis techniques can be useful for recalibrating skills and strategies to a changing market outlook. This paper discusses the role that scenario analysis techniques can play in enhancing the capability of institutions to be more innovative in recognising risks and opportunities.

The value of scenarios for institutional investors

For long horizon institutional investors, it is possible to recognise structural shifts and long-term trends that are likely to dramatically change the future investment landscape. The origins of these structural shifts come from diverse factors including technological developments, demographic change, geopolitical forces and sectoral trends including biotechnology. The challenge for institutional investors is to establish first mover capability in analysing and making sense of these long-term shifts and, more critically, determining their implications for investment strategy.

There is evidence to suggest that the macroeconomic environment may be more volatile than in the past, while trend growth for the global economy may well be lower than we experienced in recent decades. Future investment success will depend on investors’ ability to plan for various future scenarios and their ability to develop uniqueness and respond flexibly to the changing market environment.

While scenario analysis has been used extensively within corporate and public sector contexts, its application within an institutional investment context is less extensive.

What makes it a particularly valuable tool for institutional investors?

Recognising early warning signals: It allows investment committees, strategists and asset class specialists to become better at identifying the implications of change for the portfolio and allows the organisation to recognise sooner if developments move towards a certain scenario outcome. As a result, they are able to respond quickly to events in a way that would have been impossible without the mental preparation of scenario analysis.

Challenging thinking about the range of possible futures: The assumption underlying modern economics – human beings are rational decision-makers – does not fit with reality. Behavioural economics tells us that humans expect the future to resemble the past and that change will occur gradually. Scenario analysis allows us to demonstrate how and why things could change more dramatically than in the past. Testing strategies under a wider range of extreme scenarios increases our flexibility to respond to the range of possibilities the future may hold.

Creating an adaptive organisation: Scenarios provide a language for strategy discussions that brings people together towards a shared understanding of the situation. In this way, strategy becomes a natural part of any management task, rather than being the exclusive domain of specialists, allowing decision-making to happen in a timely way. While it is not possible to work out optimal strategies through a rational thinking process alone, managers can create processes within an organisation that will make it more adaptive and capable of learning from its experience.

Applying scenario analysis to develop distinctive competency

Consistent with the rationalist school, the traditional approach to developing investment strategy is a top-down approach that relies on logic. The choice of an optimal strategy is a process of searching for maximum utility among a number of alternative options. However, in a dynamic environment, traditional planning instruments have their limitations as they do not offer sufficient insight into possible future developments.

Scenario analysis differs from the traditional approach as it recognises that optimal strategies cannot be developed through a rational thinking process alone. It accepts that there is uncertainty and ambiguity in any situation and that successful strategy can only be developed in full view of this. Second, it recognises that investment success, like entrepreneurial success, derives from originality and a distinctive competency that is difficult for others to replicate (Figures 1, 2).

Developing successful investment strategy is not a once and for all activity. If successful investment strategies are to be sustained, investors need to develop distinctive competencies in identifying and addressing risks and opportunities. As distinctiveness will normally depreciate over time, a successful strategy is one that makes the institution more adaptable to the changing market opportunities and risks.

Figure 1: Strategy development method

Organisations, like individuals, can lose perspective and suffer from myopic vision or a ‘one-track mind’. If they only see and focus on one possible future and ignore evidence that points to an alternative view of the future then competitive advantage is compromised, or at worst permanently lost. Scenario analysis is an important and proven mechanism for rehearsing alternative pathways into the future as a way of expanding the field of vision. In other words, it can be your crash dummy to stress test your strategy and to simulate the opportunities and risks implied in new strategy options.

Herman Kahn, one of the founding innovators of the practice, developed scenarios to see past the cultural blind spot that thermonuclear war must never happen. Kahn asked questions such as “What if it did happen?”, “ What sort of world might the survivors face?”. Gerard Piel of Scientific American, critically coined the phrase "thinking the unthinkable" to describe Kahn's approach. However Kahn embraced the phrase as his own, arguing that thinking the unthinkable was the only way to keep one's strategic vision from becoming myopic.

Scenario analysis in practice

Scenario planning derives from the observation that, given the impossibility of knowing precisely how the future will play out, a good decision or strategy to adopt is one that plays out well across several possible futures. To find that "robust" strategy, scenarios are created in parallel, such that each scenario diverges markedly from the others.

These scenarios, essentially, explore a set of reasonably plausible but structurally different futures using storylines in which events unfold over time through a progression of cause and effect. Stories are efficient vehicles for organising data across a range of subjects and relating events causally. They provide a flexible means to connect disparate data into holistic pictures providing context and meaning for possible future developments.

Figure 2: Creating a positive feedback loop

Figure 3: Distinctive competency needed for success

Contrasting scenario analysis and sensitivity analysis

Sensitivity analysis involves considering what would happen if an important variable in the environment turns out differently than forecast. It develops a single criterion against which the various strategic options are assessed and weighted according to the probabilities of these futures materialising.

Sensitivity analysis has limitations as a decision-making tool because it does not deal with the interlinkages between the variables in the situation being considered and does not provide for internally consistent futures. To use a simple example, sensitivity analysis could be conducted on GDP growth being one percentage point higher or lower. However this would then beg the question as to whether it were reasonable to assume that inflation would be lower or higher and what the implications would be for the equity risk premium.

Unlike sensitivity analysis which examines deviations around a base case forecast, scenario analysis seeks to root out structurally different futures with the focus on causality rather than probabilities. Analysing structurally alternative futures is conceptually different from sensitivity analysis as it causes us to explore dramatically different ways that the future could unfold. Its purpose is not to forecast future events but to highlight large-scale forces that push the future in different directions. It's about making these forces visible, so that if they do happen, the planner will at least recognize them and it's about making better decisions today.

Conclusion

The ability to seek out unique strategies that can exploit structural shifts in a timely way is a comparative advantage. The essence of this process lies within your own institution and its stakeholders, with the people and insight that has accumulated from market experience. The art of the strategic conversation is a way of liberating that deep insight to identify structural shifts, and capture that opportunity or mitigate that risk.

The crash dummy simulation is there to be deployed to highlight risks and learn from extreme events. Scenario analysis, and the strategic conversation that underlines the process, allows long-term and sophisticated investors such as sovereign funds to unlock considerable value regardless of how the future unfolds.

1Word Economic Forum Global Risks 2010: A Global Risk Network Report, in collaboration with Citi, Marsh and McLennan Companies (MMC), Swiss Re, Wharton School Risk Centre, Zurich Financial Services.
2Most notable developers of the practice included Herman Kahn and later Pierre Wack at Royal Dutch Shell.
3Kees van der Heijden (1994) Probabilistic planning and scenario planning, in Wright, G & Ayton P (ed) Subjective Probability, Wiley, Chichester.
4Don Michael (1973) On Learning to Plan – and Planning to Learn, Jossey-Bass, San Francisco, CA.

Patricia Pascuzzo
Global Director of Sovereign Funds Consulting
Mercer