Investors must base their investment decisions on a set of assumptions and inputs. Sometimes, these assumptions may be uncertain and may impact their judgments. This impact comes in the form of investment risk. Therefore, investors may use various tools to assess the influence that these risks have and compare them with the benefits.
Among the tools that investors use to assess the impact of investment risk, two of the prevalent ones are sensitivity and scenario analysis. They are different from each other in various aspects. It is crucial to look at both of them to understand how they differ from each other.
What is Sensitivity Analysis?
Sensitivity analysis is a tool that investors use in financial modeling. It helps them analyze how different values in a set of independent variables affect a specific dependent variable. Usually, investors can control and specify the conditions that may dictate the relationship between the variables. While sensitivity analysis is prevalent in finance, it also has uses in other fields such as economics, geography, and engineering.
Sensitivity analysis works by establishing two variables, an input, and a target variable. It then uses the input variable to see how the target variable reacts to changes in it. The most common form of sensitivity analysis is the what-if analysis, also known as simulation analysis. By creating a set of variables, users can determine the relationship between them.
Users also analyze both the target and input variables when conducting a sensitivity analysis. During that, users examine how the changes in one affect the other. Through these changes, they can determine the relationship between those variables.
Through sensitivity analysis, users can make a prediction based on the established relationships between variables. For example, investors may use it to predict the changes in the share prices of specific companies. They may use various variables such as the company’s earnings, its number of shares outstanding, its leverage, etc.
Overall, sensitivity analysis allows users to produce forecasts based on historical data. Once investors study all the variables and their related outcomes, they can make various decisions about their investments.
What is Scenario Analysis?
Scenario analysis involves examining and evaluating possible scenarios or events that may occur in the future. Based on these scenarios, it helps users predict various possible outcomes or results. It is another tool used in financial modeling, sometimes alongside sensitivity analysis. Investors may use it to estimate changes in the value of shares. They can base it on favourable or unfavourable events that may impact the company.
With scenario analysis, users establish several scenarios to estimate future results. They can make various assumptions about each scenario and evaluate how those assumptions will impact their decisions. While users utilize sensitivity analysis for estimations, scenario analysis is more applicable for risk assessment.
Users can also use scenario analysis to evaluate the worst-case and best-case scenarios. It can help them in stress testing. Users can use computer simulation techniques to test the resilience of their investment portfolios against possible future threats. As mentioned, these tests can help in measuring investment risk and adequacy of assets.
Investors can use various methods to perform scenario analysis. Among those, the most common method is to measure the standard deviation of their security returns. They can calculate the expected value for their portfolio if each security generates variable standard deviations from the average return.
Sensitivity analysis and scenario analysis are two tools that investors may use for their investments. Sensitivity analysis helps them determine the relationship between an independent and dependent variable. Based on this relationship, they can make predictions or estimations. Scenario analysis helps investors evaluate the investment risk associated with their portfolio.