Future market performance is impossible to predict with any certainty. However, investors should still try to understand the risks that potential future events – a sharp rise in interest rates, another European financial crisis, etc. – pose for their portfolios. While nobody knows exactly how such events would unfold, that doesn’t mean that one shouldn’t be prepared. The best way to evaluate these risks is by conducting scenario analyses.
For instance, the Fed is expected to hike rates again on Wednesday, and also provide clues regarding the likely path of interest rates going forward. You may be wondering how your portfolio will fare as interest rates rise, given that many Fed tightening cycles end in a recession and/or a stock market crash. A scenario analysis can help you project your portfolio’s possible performance in different hypothetical Fed rate hike trajectories, giving you a better understanding of the risk your investments face and whether you are comfortable with that risk.
One useful practice when conducting a scenario analysis is to produce three versions of the same scenario, with each one representing a different degree of severity – e.g. “mild,” “moderate,” and “severe.” Since it is impossible to know for sure what the eventual Fed interest rate path will look like, having multiple possible scenarios for reference – a best-case, worst-case, and moderate-case – provides a more holistic understanding of the market situations your portfolio may face.
Ultimately, scenario analyses enable investors to put their portfolios through hypothetical “trial runs” of potential future market events. While they are only estimates of possible market conditions, and not guaranteed outcomes, the information they provide can still help investors manage portfolio risk, expectations, and performance.