Investment decision-making involves thinking in terms of outcomes. These outcomes can be comprehended by deeply examining the following two issues: first, the possible and expected outcomes and second predicting the likelihood of playing it for the next five years. These outcomes can be understood in terms of scenarios that are followed by assumptions like in the areas of interest rates, potential earnings, inflation, and investor appetite. An example of the scenario is the expected inflation accompanied by slow growth or otherwise called stagflation. This can be understood using the potential model for equities based on growth and valuation. In this scenario, it is imperative to use lower earnings and valuation assumptions as opposed to a more positive environment where it can be easy to contain inflation. Another scenario is one where there is normal economic recovery; the assumption is that there is a likelihood of normal recovery from stagflation and deflationary climate. These scenarios are arrived at from realities such as financial stress in households, stretching of government resources, and the outright mistakes of policymakers. The positive likelihood of this scenario includes the long-term impact on earnings from the increasing market demand.
Critique and its Application in Financial Management
Every business and investment is characterized by a particular degree of uncertainty and the potential outcomes may be unanticipated. With this scenario, financial advisors and institutions should diligently manage the assets and be able to meet the financial goals for their clients. Modern investments require that financial assessments and actions should be based on a mysterious future; financial advisors and institutions should always have this in mind and accept to address this inescapable reality.
For a company to analyze the rate of relative returns and investment categories, it should study the current economic environment and compare it to another economic environment in a different time span. This can be evaluated based on a wide range of macroeconomic scenarios that might come to play over a particular period of time.
There is no guarantee that the outcome from the scenario is accurate but it only depends on decision making by the firm especially due to the irrational and uncontrollable nature of the market. In an economic environment, there can be a tendency of ground shifting and this is not limited to the current period. It is always necessary to identify and comprehend all the variables that affect investment in order to factor it into perspective or potential assumptions and outcomes. In the case of the 2008 financial crisis, an anticipated course of action has to be considered. The action was to be based on a market scenario 20 years before where the selling of stocks after a 20 percent decline was unfathomable and unproductive. This enabled companies to lower their equity exposure, though it was a criticized measure but it helped to save the companies to reduce losses and enabled them to grasp the opportunities which could benefit them through high yield bonds.
There should be strong convictions in making investment decisions. Some of the economic values can be measured while others are difficult to understand and can not be used to base investment decisions. Measurable economic aspects are like yields of interest rate whereas the immeasurable ones are like political will. Every investment firm should have lead analysts who will factor in assumptions and forecasts for all the metrics necessary in economic scenarios and also identify errors in assumptions. In order to paint a vivid picture of scenario analysis, it is important to refer to external sources fro published research work and conference papers for further information (Lowenstein, 2011).
Lowenstein, A. (2011). Identify Potential investment outcomes with scenario analysis. Journal of Investment Planning, 1(1), pp. 44-45.