Your return models may require some degree of building from the bottom up. For instance, estimating the returns of equities in major countries (or industries) may be necessary to generate global equity returns. But this requirement should not necessarily drive the number of asset groups over which you are making asset allocation decisions. After all, strategic asset allocation should be used for no more that setting the overall shape of the fund’s portfolio; it should not result in artificial constraints on the investment teams that select individual investments. The next stage in this process is to assign probabilities to each scenario. Once again, this requires judgment. Perhaps the easiest way to do this is to use a small number of “likelihood labels”, such as “likely”, “possible”, “plausible” and “unlikely”. Each label could be given a weight, such as 10, five, three and one respectively. Then assign each scenario a likelihood label.

The probability of a scenario is then just its weight divided by the sum of the weights. The result is joint nonparametric probability distribution of rates of return for each asset grouping. This is akin to the joint normal probability distribution as described by means and covariances. But there is a crucial difference: the non-parametric distribution is derived from careful thinking about the future, rather than shoehorning the past into the normal distribution. From here the investment team can apply stochastic asset/liability analysis to discover investment strategies that are likely to deliver robust outcomes for the investment objectives of the fund. This non-trivial task is beyond the scope of this article. So what? Using scenarios analysis means that you don’t have to be hidebound by the convenience of mean/variance analysis. It’s impossible to forecast the future – so don’t. Instead, imagine a set of possible futures. Have fun creating a plot (with characters, if you like) for each scenario. Develop the qualitative narrative, and then turn over an envelope and guesstimate how each key asset class may perform in each narrative. You don’t have to be convinced that that future will occur. But thinking about it in these terms will make you better positioned if the world moves in that direction.