What does scenario analysis involve?

Scenario analysis involves assessing the potential impacts of various hypothetical situations on a portfolio's performance. This method evaluates how different plausible but unusual circumstances could affect financial outcomes. For example, it might simulate the effects of significant economic shifts, changes in interest rates, or geopolitical events on investment returns.

This approach helps investors understand the potential risks and rewards associated with their portfolios under specific scenarios that, while not necessarily expected to occur, are conceivable and can significantly influence investment results. By employing scenario analysis, investors can better manage risk by preparing for adverse conditions and making more informed decisions about asset allocation.

The other options reflect different aspects of investment analysis. While analyzing theoretical market crashes focuses more narrowly on extreme negative events, measuring standard deviation of returns relates to understanding volatility, and tracking individual securities involves monitoring specific investments rather than assessing broader portfolio responses to varying scenarios. Scenario analysis, therefore, uniquely emphasizes a systematic exploration of diverse potential outcomes rather than singular or isolated metrics.