A scenario analysis is a risk measure where an advisor uses a computer model or some other method to predict the portfolio loss under certain adverse conditions. The most popular stress test is a market crash, but there are others frequently used as well, such as rapidly rising interest rates or commodity spikes.
If there is a particular concern in the market at a given time, there is probably a scenario that might give clients a way to understand what it might mean for them.
The #1 Good:
One benefit of scenario analysis is that it can describe risk in terms of dollars and cents, which all investors understand. But a potentially even larger benefit is that it can give a client a real world context around how bad that scenario is and how likely or unlikely it might be. A good example would be, “If we were to have another market crash like 2008, we would estimate your temporary loss to be 23% or $85,000.” Assuming the client was invested or news-aware in 2008, they might be able to better understand how rare that is expected to be and how severe compared to other losses.
The #1 Bad:
Possibly the biggest problem with scenario analysis is that most reports do not describe the loss within the context of what has already occurred in the market. For example, you might run a report showing your client an estimated loss of approximately 20% if the market were to have a crash like 2008. If the market then declines 25% and the portfolio is off by 12% already, your report will probably still read a loss of 20%, implying that the decline could be a FURTHER 20% from there, which would make for a total loss of 29.6% vs the original 20% estimate. This has the potential to sew confusion and distrust at a particularly inopportune time. Communication in these instances will be key.
You can read the full article on Advisor Perspectives: https://www.advisorperspectives.com/articles/2022/03/07/using-analytics-in-wealth-management-the-good-and-bad