Future perfect

Scenario planning can help you do well no matter which way the market goes. The only requirement? A bit of imagination

By Wynn Quon | June/July 2001

When my friend James, an Ottawa software designer, paid $104 a share last year to buy 100 shares of Nortel Networks, he believed the Canadian telecom giant was poised to dominate the global fibre-optics market. At first, his faith was rewarded as the stock climbed higher on the strength of the company's optimistic projections for future revenue growth. But then came a shocker.

In October, Nortel announced its earnings would fall well below expectations. Investors began to rush for the doors. The same analysts who had been singing the company's praises threw down their song sheets and began to lambaste the firm for missing its targets.

Nortel's downward slide took many weeks to fully unfold, but to James the stock's disintegration seemed to happen on fast-forward. Completely unprepared for the bad news – he had never even imagined the possibility that Nortel could fall so far, so fast – James didn't handle the episode well. As he watched the value of his Nortel block fall from $10,400 to $2,000, he felt paralyzed, unable to sell. "I was on pins and needles all the time," he says ruefully. "There was hardly time to think before–bang, the stock would go down again."

Today, James has accepted his loss, and even sounds philosophical about it. But he still wonders if there's something he could have done differently, some method that would have allowed him to react better when the market moved so decisively against him. "I got caught up like everyone else, but the thing that bugs me is how it turned so bad so quickly," he says.

The good news is that there is a technique that can save you from suffering the same paralysis of indecision that afflicted James. It's a simple yet powerful tactic called scenario planning that I believe should be used by every investor at least once a year.

Scenario planning isn't complicated. It consists of thinking through, in a logical, organized fashion, the different ways in which events could unfold in the future, then seeing how well-prepared you are for each eventuality. You can think of it as a what-if game. What if corporate earnings continue their slide? On the other hand, what if the economy recovers more quickly than most people think possible?

Scenario planning first gained prominence in the ‘70s when Royal Dutch/Shell used it to successfully anticipate the OPEC oil crisis. Since then, the technique has been embraced by industry and governments alike. Aid agencies have used it to map out paths to sustainable development in countries such as South Africa, Colombia and Kenya. In Canada, it's used by the Task Force for the Future of the Public Service to brainstorm what the civil service could look like 10 years into the future.

Scenario planning doesn't try to say what will happen because the future is unknowable. Rather, it stresses being prepared for what may happen–and that includes unlikely events as well as likely ones.

You can apply the technique to your own investment plans by using some basic stock market history to come up with best- and worst-case scenarios. You then "test" your investment plans against these scenarios. If the worst case causes you to lose most of your retirement assets, then it's time to re-examine the way you've allocated your portfolio.

Sounds easy, doesn't it? Yet despite its apparent simplicity, scenario planning is a great way to overcome the psychological blind spots that distort our view of the world. Behavioral-finance experts have catalogued many of these reality-bending mental tics. One of the most common is the "recency effect"–the tendency of people to put too much trust in recent events and to see the latest trend as a reliable predictor of what lies ahead. Another deceiving tendency is what's known as "confirmation bias": our habit of taking to heart stories that reinforce our beliefs, while rejecting news or opinions that go against our world view.

During the recent high-tech bull market, you could see both recency and confirmation bias at work. Many bulls became emotionally committed to their position and, instead of questioning their assumptions, searched only for confirming evidence of their optimism in the pages of Fast Company magazine and other e-business cheerleaders. As prices climbed higher and higher, it was easy to think the market would keep rising indefinitely. Blinded by recency, many analysts proclaimed that it would be impossible for Nortel to fall to $20.

Scenario planning could have helped the tech investor break out of the bull-market mind-set brought on by recency and confirmation bias before it was too late. These days, it can help us break out of the doom-and-gloom mind-set that's typical at bear-market bottoms.

If you want to do your own scenario planning, there are four steps to follow. Let's look at each in turn.

Step 1: Get the facts

To understand what to expect from the stock market, you need to examine how markets have behaved in the past. The single most important figure you should remember is 7%. Why 7%? Because that's the average annual after-inflation return that stocks have produced over the past century, and it's the best single estimate of what you can expect as a long-term stock market investor.

The 7% figure may surprise you. Many new investors think they should expect 20% gains as a matter of course. Unfortunately, history says they're dreaming.

In fact, the 7% returns produced by the stock market look postively lush compared to the returns from other asset classes. The after-inflation gains from stocks are way ahead of alternatives such as bonds (average returns of 2.7%), treasury bills (1.7%) or gold (0.01%).

Of course, what the long-term averages don't convey is the volatility of returns. Saying that stocks reward you with an average after-inflation return of 7% is a bit like saying that the average temperature in Edmonton is 14 degrees. While that may be true, someone who prepared only for the average case would freeze to death during the depths of an Alberta winter.

Stock market investors face their own version of foul weather. Down and dirty lists the bear markets of the past century or so. (I've used the Dow Jones industrial average rather than the TSE 300 because the TSE numbers don't stretch as far back.) The table may come as a shock to investors accustomed to the boom years of the '90s. In the last 102 years there have been 20 bear markets. The typical bear market has taken the market down 37%. Instead of being an anomaly, the market plunge of this past year has been entirely normal, and even mild by comparison to bear-market debacles of the past.

The question is how long the bad news will last. Postwar bear markets have lasted an average of only 14 months, but the past century has also included two truly disastrous periods for the stock market. From 1929 to 1932, stocks fell 89%: and share prices took 25 years to return to their 1929 level. More recently, the market stagnated for more than a decade during the inflationary '60s and '70s. After a series of strong rises punctuated by equally strong declines, the Dow Jones industrial average finished 1981 at the same level as it did 1964. Even if you're a long-term investor, a 17-year period without any net capital gains is likely to test your patience!

These historical figures suggest that realistic investors should prepare themselves for bursts of strong gains, interspersed with stagnant periods and frequent bear markets. If you want to be a successful investor, you have to rein in your optimism when things are going wonderfully, and take advantage of profit-making opportunities when things appear to be at their worst.

Fortunately, by comparing current conditions to past situations, we can inoculate ourselves against unreasonable panics and manic enthusiasms. Take a look at Buy signals. It summarizes the key facts about the cost of buying shares based upon the market's price-to-earnings ratio, a key indicator of how expensive stocks are at any moment. This ratio has historically been around 15. At the moment, it's over 20, a level that suggests stocks are very expensive and that returns for the next decade will likely be closer to 5% than the 7% historical average. Let's keep that figure in mind as we construct our scenarios for the future.

Step 2: Set your personal goals

Before you can construct realistic scenarios, you need to size up your personal situation and come up with a financial plan. This plan is like your shoes. A perfect fit for you may be uncomfortably tight or loose for someone else.

To start constructing your financial plan, list your goals and put a realistic cost beside each. Do you want to put aside money for your own tuition or for your kids' education? How about saving for a down payment on a house? Or putting away funds for retirement? For each goal you should list not only the amount you would like to have, but at what time you will need the money.

Next, you have to think about your risk tolerance. If you lost sleep over this year's stock market gyrations then you've probably set your stock market exposure too high. The good news is that the process of scenario planning will help you figure out what a more comfortable level might be.

Step 3: Use your imagination

Because of recency, we tend to look only at the immediate past when we make our financial decisions. This narrow perspective often blinds us to the harsh reality that the economy does not proceed in a straight line. To break out of this mental trap, you should begin your scenario planning by generating best-case, average and worst-case scenarios for what will happen in the stock market over the next year.

These scenarios should range widely since the whole point of this exercise is to prepare yourself for the unexpected, but you can make use of stock market history to put some limits on your imagination. If the market has been growing steadily for years, your worst-case scenario should involve a bear market crash. On the other hand, if the market has been losing ground for a year, your best-case scenario should include the possibility of a rebound. In either case, you can gauge what's reasonable by looking at the market's price-to-earnings ratio and comparing it to historical levels.

Here are three scenarios based on today's conditions that you might want to consider as you plan your portfolio:

Scenario 1: The current economic slowdown is followed by a strong recovery in the second half of the year as central banks in the U.S. and Canada chop interest rates. Economic growth in North America rebounds to around 4%, while financial reform in Japan reignites growth in Asia. Result: the TSE and the Dow shoot upward, past the 12,000 level. Price-to-earnings ratios hit an average of 30, nearly double the historical average.

Scenario 2: Recession and an average bear market. The economy shrinks slightly but interest rate cuts help to cushion the shock. Technology spending declines but remains robust. The wave of high-tech failures slows and then stops, paving the way for a gradual recovery. Stocks fall to price-to-earnings levels that are more in keeping with historical norms, and the Dow and the TSE settle 30% below their peaks.

Scenario 3: Severe recession and a bear market on the order of the '70s. The slowdown triggers an avalanche of business and consumer bankruptcy. The collapse of the New Economy, especially in Silicon Valley, causes a financial crisis as banks choke on defaulted mortgages and loans. Government deficits soar and the economy goes into a downward deflationary spiral. Unemployment soars to 10%. The Dow and the TSE plunge to 4,500.

Step 4: Test your portfolio

In the final step, we take the scenarios we've generated and see how our portfolio would do in each. The process is like conducting wind-tunnel tests on a new airplane model. Aeronautical engineers want to be sure their new design can handle a variety of wind conditions before it actually reaches 20,000 feet. In the same way, you want to be sure your portfolio can withstand bad investment weather before it strikes.

Books of revelation

These volumes can help you see where the stock market is going by showing you where it's already been. If you're interested in coming up with your own scenarios, you need a firm knowledge of stock markets and how they've behaved in the past. These two books provide all the basic information you need:

A Random Walk Down Wall Street by Burton G. Malkiel. Now in its seventh edition, this book is a treasure trove. It covers the best strategies to use in the stock market as well as looking at what stock markets have done over the past four decades. The chapter on stock market bubbles is particularly timely. If more people had read it, we would have avoided the Nasdaq disaster.

The Wall Street Waltz by Kenneth L. Fisher. If you like pictures, this is the book for you. Its more than 90 historical graphs and charts answer all kinds of questions about financial cycles and trends, and explode plenty of myths along the way. Do interest rates really predict the stock market? How high were P/E ratios during the ‘20s? The book was written more than 10 years ago, so it doesn't cover the '90s, but despite its age, it's still a valuable primer.

Here's an example: Judy is a 44-year-old single mother with a son who will be attending university next year. As of last September, she had net assets worth $40,000 ($5,000 in cash, the remainder in a mutual fund that tracks the TSE 300 stock market index). She expects she will need $10,000 a year for the next two years to help put her son through school.

If Scenario 1 comes to pass, Judy is fine. Her $40,000 portfolio increases its value. Under Scenario 2, Judy's $40,000 portfolio falls to $24,000. That hurts, but she still has enough to cover the $20,000 she has earmarked for her son's education. Disaster comes only if Scenario 3 strikes. In that situation, her portfolio will plunge to $16,000, definitely not enough to meet her needs.

Recognizing this, Judy could reduce her risk in several ways. Her easiest plan would be to take $5,000 out of her equity mutual fund and put the money in a money-market fund, giving her a total of $10,000 in cash or cash equivalents. Even if the horror of Scenario 3 strikes, she will still have $22,000 to meet her obligations, well above her minimum requirement.

Alternatively, Judy could reduce her risk by switching her money from the TSE 300 index fund to a less risky balanced fund, which invests in both bonds and stocks. If she were a sophisticated investor, she could also consider purchasing a small amount of long-term put options on the TSE market index (so-called "Put LEAPs"). These are essentially bets that pay off if the market tumbles. But regardless of how she reduces risk, she won't panic if a stock market apocalypse hits, because she has already prepared for it and thought through her response.

In this example, scenario planning encourages Judy to reduce risk, but the technique can also be useful at prodding overcautious investors to take on more risk. Let's consider Patrick, a 30-year-old accountant. He's single, he has $20,000 in Canada Savings Bonds in his RRSP and he considers himself to be a highly conservative investor. He plans on socking away $10,000 in his RRSP every year with the goal of being able to retire sometime in his mid- to late 50s with a million dollars.

That all sounds good, but if Patrick does some scenario planning, he will come to a depressing conclusion. Even if he holds true to his intention to contribute $10,000 a year to his portfolio, the 4% return he is likely to reap from his savings bonds won't get him anywhere close to his million-dollar target. To achieve his goal, he is going to have to achieve a higher return and that means buying stocks.

He could leap into the stock market right away, but if he were to invest all of his savings in stocks he might be taking on more risk than he wants. If Scenario 3 comes to pass, and his portfolio follows the course of the overall market, he will lose about $5,000.

If Patrick finds the possibility of losing this much money too painful to contemplate, he could reduce his risk by watching the average price-to-earnings ratio of the stock market and investing in equity mutual funds only when the average drops below 18 or so–as would happen in the aftermath of Scenario 2 or Scenario 3. This strategy may entail a bit of waiting, especially if Scenario 1 comes to pass, but it will ensure that Patrick doesn't buy into the market at a peak.

An even simpler option would be start investing regularly in a balanced fund or a dividend income fund, which invests in dividend-paying blue-chip firms. Either alternative will probably pay more over the long run than the Canada Savings Bonds that Patrick holds now. And since he has years before he will need to tap his money, he has plenty of time to ride out any market turbulence.

Whether you're like Judy or Patrick, scenario planning can be invaluable. It allows you to escape from conventional wisdom and prepare yourself for the unexpected. Time and time again, in my own investing, I've been struck by scenario planning's ability to shake me out of comfortable assumptions.

Want a real-life example of its usefulness? Look back at the May 2000 issue of MoneySense. I wrote an article entitled Cliff-hanger that was partly inspired by my work with scenarios based on earlier technology booms. The article warned of an impending collapse in tech stocks. Readers who took action then were prepared for the brutal 60% decline of the Nasdaq.

My advice? When the future is murkiest, take the time to sketch out a few scenarios that extend your vision of what could happen down the road. At the worst, you'll lose a few minutes. At the best, you could save yourself a bundle.