What If?

During a recent driving lesson with my son, I narrated aloud what I was thinking along the road—at each intersection, entering and exiting the freeway and so on. After five minutes, he looked at me and said, “Driving is a lot of ‘what ifs’, isn’t it? – What if that car doesn’t stop, what if they make a left-hand turn in front of me, what if you don’t stop talking while I’m learning to drive?”

You get the picture.

Investing on behalf of clients is similar. It is a process of evaluating objectives, putting a financial plan together and then building a portfolio of investments to achieve a desired outcome. Along the way, there are a lot of “what ifs.” As we evaluate our portfolios throughout the year, asking “what if” often leads to a process called scenario analysis.

Building scenarios

There are a lot of variables that drive the value of stocks, bonds, real estate, commodities and so on. How well is the economy doing? How are interest rates moving? Where are the levels of inflation and employment both here and abroad? How profitable are companies going to be in the future?

The price of assets reflects expectations. Not about the here and now, but about the “what if.”

To build a portfolio that considers so many variables, our investment committee spends time each month looking at a set of “what if” scenarios, such as:

• Soft landing
• Stagflation
• Global recession, and others.

To build these scenarios, we use a software tool, MSCI Barra Models. Here are some sample inputs into the scenarios. For example, see the “Soft Landing” scenario column. Here we’ve entered assumptions consistent with a fairly rosy, recession-free path forward for the economy. These include double-digit stock returns, substantial reductions in interest rates and inflation, and a modest reduction in oil prices.

Once we’ve entered our factor assumptions, we run portfolios through the scenario models, with a focus on where we can mitigate downside risks.

What if it’s not so soft?

If this were a menu, we’d order up the Soft Landing scenario. But for risk management purposes, the gloomier scenarios are even more important to consider.

We all know inflation has been a significant challenge for consumers, businesses and policymakers. High inflation causes prices to rise at a more rapid pace, eats away at consumers purchasing power and makes it harder for companies to generate profit because their cost of goods and labor is rising faster than they can increase prices.

So, the “Stagflation” scenario shown above is the worst outcome because it implies that higher interest rates can’t cool the economy enough or change behavior enough to keep inflation down. Note that our input assumptions for Stagflation include persistently high inflation, even higher interest rates and a big increase in oil prices--not to mention double-digit negative stock returns.

Having built the model, we use the tool to “shock” our current portfolios with the Stagflation scenario as if it came to fruition for the next 12 months. I won’t get into the math, but suffice to say if you love statistics, covariance matrices and the like, you’d enjoy a deeper explanation. Feel free to email me, and I’ll share more details.

Running portfolio tests using several models lets us shape a portfolio for the “what if” scenarios we think are most likely to occur. This is an iterative process. We return to it again and again as markets and the economic environment change.

Advisor & client use of scenarios

In addition to use in portfolio construction, model output can also help advisors working with clients on their financial plans. Our advisors can then help prepare clients for the possibility of different outcomes during a market cycle. Feeling prepared for “what ifs” is an inherent benefit of working with an advisor.