Unraveling unpredictability: effective scenario analysis can help clients deal with uncertainty.

• Author: Salvini, Brooke A.
• Position: Financial planning

in periods of high uncertainty, it's not enough to recommend to clients that they keep their retirement savings diversified and to stay the course with their investments. Although academic evidence supports this as a sound, long-term investment strategy that leads to the most successful outcomes, the advice sounds thin when times are turbulent--and frequently isn't enough to truly assuage the deep fears of some clients.

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Moreover, the stay-the-course strategy isn't enough to help clients with appetites for risk find opportunities.

As a most trusted adviser we can play a large role in helping clients understand and cope with the risks and opportunity generated by uncertainty. We can do this by using scenario analysis to help ground them in reality and lighten their fear of the unknown.

For example, earlier this year during a period of higher uncertainty, I found it helpful for a very risk adverse and nervous client to map out their exact concerns by using financial modeling software. What if the value of their retirement savings dropped by 40 percent, pension income was cut 10 percent and their home value fell by 20 percent? Could they successfully weather the downturn? Would they have to go back to work? Or worse: Would they have to depend on their children for financial support?

When we plugged in these scenarios, we discovered their fears were unfounded. Even if they realized a big loss in wealth as modeled in a worst-case scenario, the client would have enough to enjoy their current lifestyle. They probably wouldn't leave as much to the children, but enough to care for themselves through their elder years. Equally important would have been to learn that serious lifestyle changes would be necessary to deal with a change in circumstances.

As a CPA financial planner I helped this client flush out their fears and make realistic assessments of risk and opportunity based on evidence.

Scenario Analysis & Storytelling

Scenario analysis is the tool to deal with an unpredictable future--and is possibility the next best thing to the crystal ball.

Stress testing of portfolios with Monte Carlo simulation is an important single variant analysis, but multi-variable scenario modeling adds the planning depth to help the client visualize possible futures. Scenario analysis has been a regular part of enterprise risk management for years and can be equally effective when applied in personal financial planning engagements.

The goals arc...