“Scenarios deal with two worlds; the world of facts and the world of perceptions. They explore for facts but they aim at perceptions inside the heads of decision-makers. Their purpose is to gather and transform information of strategic significance into fresh perceptions. This transformation process is not trivial—more often than not it does not happen. When it works, it is a creative experience that generates a heartfelt ‘Aha' … and leads to strategic insights beyond the mind's reach.”
- Pierre Wack
Building scenarios is a key creative process for investment management. You can get a quant to run an optimizer, and you can get a good analyst to tell a strong narrative with supporting documentation, but building alternatives for future market performance is much more difficult. Many simplify this process by just providing three scenarios, an optimistic, pessimistic, and a base or status quo. That is a form of scenario analysis, but it is not effective scenario building. It may not provide the deep thinking of how changes in the economy, adaptive expectations, and capital flows interact to create new return worlds.
The classic scenario is usually just built around expected return or price estimates. A portfolio manager will run a likely case based on his best guess of what may happen across a set of asset classes. There may be a narrative attached based on a set of assumptions with how markets respond to news. From this base case, there will be a positive (good news) scenario that will have higher returns for riskier assets and a negative (bad news) scenario where risky assets fall in value. Each scenario is given a probability and the portfolio upside, downside, and likely scenario are assessed to determine risks. This is not a bad way of looking at alternatives and is consistent with the method taught in most business schools. but it is not an effective way for conducting deep portfolio planning.
Pierre Wack was the leading scenario planner for Royal Dutch Shell and revolutionized thinking about scenario thinking in the 70's. Unfortunately, he has not been studied extensively in more recent history and never gained any traction in the world of finance. The processes of running scenarios for a large corporation are different than for an investment portfolio. Corporate risks are greater because capital investment decisions need to be made with long lead times. The costs of being wrong are also higher given there is less diversification with focused industrial company. Nevertheless, the deeper operational thinking and examination done by our best corporation should be applied to investment portfolio construction.
Wack did not come out of the quantitative world so his thinking did not fit with normal optimization and scenario analysis. A focus on perceptions has never been a normal part of investment thinking. Hence, he is an obscure figure for money managers. Nonetheless, he can teach us how to make better decisions by embracing an uncertain world.
The premise of good scenario analysis is that managers have to be engaged with the relationship between facts and alternative perceptions. It is not using the same thinking with a good or bad state of the world, but developing thoughts on alternative models of thinking.
For example, the normal view is that larger debt supply should lead to higher rates, yet the facts suggest that larger deficits have been consistent with lower rates. The perception of many for how the world works does not fit the facts, so we have to think through alternative perceptions of reality, or alternative model of how markets operate.
Another instance of changing reality is thinking about modern monetary theory (MMT) and the cost of financing deficits with money. Few would have thought just two years ago that MMT would be given much deep thinking, yet politicians, policy-makers, and investors are all now discussing it as an alternative for running fiscal and monetary policy.
A similar story could be told about trade wars. The role of China in the world economy and how trading partners work with China have changed radically in the last year. Scenarios for how countries will engage with trade will truly impact return profiles with both winners and losers that cannot be described in good and bad scenarios.
Perceptions change and those alternative realities have to be considered. Once we form alternative perceptions, we can discuss what will happen with new disruptions of shocks to markets and the implications across assets. Investors can then think through a set of alternative investment choices.
The market disruptions in 2008 were a failure to think through how shocks may promulgate through markets. It was a failure of broadening our perception on risk, liquidity, and market reactions. In the post crisis period, no one would have perceived that there would be $11 trillion of negative yielding bonds.
Deep scenario thinking asks those engaged in the process to walk through the implications of whether their assumptions of market behavior are wrong or at least how they should be weighted relative to the thinking of others. There is no optimization model for a good scenario process and it cannot be structured as set of rules. Scenarios require thinking about new investment worlds.
The classic scenario is usually just built around expected return or price estimates. A portfolio manager will run a likely case based on his best guess of what may happen across a set of asset classes. There may be a narrative attached based on a set of assumptions with how markets respond to news. From this base case, there will be a positive (good news) scenario that will have higher returns for riskier assets and a negative (bad news) scenario where risky assets fall in value. Each scenario is given a probability and the portfolio upside, downside, and likely scenario are assessed to determine risks. This is not a bad way of looking at alternatives and is consistent with the method taught in most business schools. but it is not an effective way for conducting deep portfolio planning.
Pierre Wack was the leading scenario planner for Royal Dutch Shell and revolutionized thinking about scenario thinking in the 70's. Unfortunately, he has not been studied extensively in more recent history and never gained any traction in the world of finance. The processes of running scenarios for a large corporation are different than for an investment portfolio. Corporate risks are greater because capital investment decisions need to be made with long lead times. The costs of being wrong are also higher given there is less diversification with focused industrial company. Nevertheless, the deeper operational thinking and examination done by our best corporation should be applied to investment portfolio construction.
Wack did not come out of the quantitative world so his thinking did not fit with normal optimization and scenario analysis. A focus on perceptions has never been a normal part of investment thinking. Hence, he is an obscure figure for money managers. Nonetheless, he can teach us how to make better decisions by embracing an uncertain world.
The premise of good scenario analysis is that managers have to be engaged with the relationship between facts and alternative perceptions. It is not using the same thinking with a good or bad state of the world, but developing thoughts on alternative models of thinking.
For example, the normal view is that larger debt supply should lead to higher rates, yet the facts suggest that larger deficits have been consistent with lower rates. The perception of many for how the world works does not fit the facts, so we have to think through alternative perceptions of reality, or alternative model of how markets operate.
Another instance of changing reality is thinking about modern monetary theory (MMT) and the cost of financing deficits with money. Few would have thought just two years ago that MMT would be given much deep thinking, yet politicians, policy-makers, and investors are all now discussing it as an alternative for running fiscal and monetary policy.
A similar story could be told about trade wars. The role of China in the world economy and how trading partners work with China have changed radically in the last year. Scenarios for how countries will engage with trade will truly impact return profiles with both winners and losers that cannot be described in good and bad scenarios.
Perceptions change and those alternative realities have to be considered. Once we form alternative perceptions, we can discuss what will happen with new disruptions of shocks to markets and the implications across assets. Investors can then think through a set of alternative investment choices.
The market disruptions in 2008 were a failure to think through how shocks may promulgate through markets. It was a failure of broadening our perception on risk, liquidity, and market reactions. In the post crisis period, no one would have perceived that there would be $11 trillion of negative yielding bonds.
Deep scenario thinking asks those engaged in the process to walk through the implications of whether their assumptions of market behavior are wrong or at least how they should be weighted relative to the thinking of others. There is no optimization model for a good scenario process and it cannot be structured as set of rules. Scenarios require thinking about new investment worlds.
