However, as discussed in our previous article, simplistic Monte Carlo simulations have shortcomings and may generate results that do not fully account for major economic and market shock events (such as Covid-19), and a rapidly evolving macroeconomic arena.
In an investment climate in which market shocks are dominant and the degree of uncertainty is very high, an advanced tool for generating and analysing plausible risk-return scenarios is more important than ever. An ideal model would be adaptive and time-varying, and thus be able to dynamically account for current market conditions and factor in uneven distributions of results in real-time.
Introducing Economic Scenario Generators
A better portfolio projection model can offer more realistic and useful insights for advisers and their clients in changing market conditions. What should an adviser look for? An advanced probabilistic model is also known as an Economic Scenario Generator (ESG). Let’s take a closer look.
An ESG recognises that past events and performance only represent one specific possible outcome. A robust ESG considers past events, but can repeatedly generate scenarios based on the effects of other possible outcomes. The main distinguishing value between an ESG-powered model and a Monte-Carlo-driven one is the quality of the underlying assumptions.
Unlike Monte Carlo models, ESG makes use of “stylised facts” based on real-world features and behavioural patterns of financial markets. Stylised facts include non-normal distributions of portfolio returns, tail risks, business cycle dynamics and time-varying risks and volatility. Factoring in these stylised facts can lead to more realistic scenarios and probabilities, which offer investors the following benefits:
- Scenario analysis that offers a full range of “more likely” and “less likely” outcomes
- A more detailed picture of risk-return tradeoffs
- Portfolio projection that can take future economic and market shocks into account
- Portfolio monitoring readjusts probabilities and tracks portfolio progress based on significant changes in the market and economic conditions.
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