Predictions, Forecasts and the Value of Scenario Analysis

ScenarioAnalysisColorGraphAccording to the The Wall Street Journal, “In Uncertain Times, CEOs Lose Faith in Forecasts” and “CEOs Put Less Stock in Predictions,” which is the title of an abbreviated article in the July 13, print edition.

The authors state that “uncertainty has been a given for business since the financial crisis, but business leaders say recent events have diminished their faith in forecasting.” They also quote an executive who says that economists are wrong as often as they are right, and they reference a study that shows over the course of 20 years, geopolitical predictions by “experts” were only slightly better than chance. We’re not sure if the world is more uncertain now than before 2008. Likewise, scepticism about specific forecasts is justified now and has always been justified. The real question is: when running a business, what are you going to do about the uncertainty and possible harm?

Interestingly, the print version excludes the best answer to our question: “use scenario planning to prepare for an unlikely, yet influential event.” The online version gives the example of Rupert Duchesne, the chief executive at Aimia Inc., who analyzed scenarios prior to the Brexit vote, and “…was able to say clearly what the impact would be on our business.” As we noted in a recent post, it seems that many domestic banks–particularly those without operations in London–had not considered the implications, and were unable to make such statements either before or immediately after last month’s vote.

So, if scenario analysis involves determining the effects of possible, future events, how is that different than making a prediction or a forecast? Actually, making a prediction or forecast is usually a special case of a scenario analyses–where the scenario considered is either the expected case or the most-likely case across all possible scenarios. That’s much like asking, “will the team win the game or the championship?”

Scenario analysis for risk management involves considering the effects when certain, potentially harmful conditions or situations occur (or evolve over some period of time). It’s more like asking, “will the team win the game or championship if its star player is injured?” Or, “how can the team win the game (or championship) if its star player is injured?” Note that asking “how” is very important because it forces consideration of appropriate (1) precautions, (2) insurance and (3) contingency plans and actions.

  1. By “precautions,” we mean actions to reduce the possibility of negative or harmful situation occurring. For example, in football if the star quarterback’s performance determines the success of the team, then precautions include hiring a protective offensive line or designing quick plays that minimize the chance of injury.
  2. By “insurance,” we mean, ex ante actions or contracts that reduce or mitigate lost should the harmful event occur. Obviously, this includes various types of actual insurance as well as hedging activities, but it also includes upfront actions that lead to diversification benefits. To continue our football example, it may include paying for a star running back, who can be the focus of the offense, or hiring an exceptional backup quarterback who can play, if the star is injured (or injury-prone).
  3. By “contingency plans and actions,” we mean intentions that are considered ex ante, but unlike precautions and insurance, not executed until after the event occurs. In football, these include changing the game plan after the quarterback is injured to compensate for his absence ors hiring an unemployed quarterback to serve as the backup’s backup.

Read more about these and other benefits of scenario analysis here. Our football examples illustrate the prevalence of scenario-based thinking for many common decisions. For more on that topic, please read Try to Be Like Me… and You.

When those benefits are combined, they tend to produce flexible, robust and resilient organizations that can anticipate, withstand, and counter adversity or adversaries–whether foreseen, or not. An illustrative example is the fable, The Three Little Pigs. Cheap and easy straw and stick houses don’t protect lazy pigs against wolves or much else. A brick house provides security from the foreseen harms, like the Big Bad Wolf, as well as others unpleasantries like rain and wind. Moreover, even in cases of fire, the brick exterior usually remains–unlike all-straw or all-twig houses, and that reduces total losses.

If you think our fabulous example is silly, please see another WSJ article, Grid Attack: How America Could Go Dark, and let us know what types of substations our utilities build and the level of operational risk management and scenario planning that you infer that those firms perform. Yeah, we’re purchasing a gas generator for corporate HQ ASAP.