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The Journal of Portfolio Management

The Journal of Portfolio Management

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Enhanced Scenario Analysis

Megan Czasonis, Mark Kritzman, Baykan Pamir and David Turkington
The Journal of Portfolio Management March 2020, 46 (4) 69-79; DOI: https://doi.org/10.3905/jpm.2020.1.125
Megan Czasonis
is a managing director at State Street Associates in Cambridge, MA
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Mark Kritzman
is the chief executive officer of Windham Capital Management in Boston, MA, and a senior lecturer at MIT Sloan School of Management in Cambridge, MA
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Baykan Pamir
is an assistant vice president at State Street Associates in Cambridge, MA
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David Turkington
is a senior vice president at State Street Associates in Cambridge, MA
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Abstract

Investors have long relied on scenario analysis as an alternative to mean–variance analysis to help them construct portfolios. Even though mean–variance analysis accounts for all potential scenarios, many investors find it difficult to implement because it requires them to specify statistical features of asset classes that are often unintuitive and difficult to estimate. Scenario analysis, by contrast, requires only that investors specify a small set of potential outcomes as projections of economic variables and assign probabilities to their occurrence. It is, therefore, more intuitive than mean–variance analysis, but it is highly subjective. In this article, the authors propose to replace the subjective elements of scenario analysis with a robust statistical process. They use a multivariate measure of statistical distance to estimate probabilities of prospective scenarios. Next, they construct portfolios that maximize utility for investors with different risk preferences. Last, the authors introduce a procedure for minimally modifying scenarios to render them consistent with prespecified views about their probabilities of occurrence.

TOPICS: Portfolio management/multi-asset allocation, risk management, quantitative methods

Key Findings

  • • The authors use a multivariate measure of statistical distance to estimate probabilities of prospective scenarios.

  • • They construct portfolios that maximize utility for investors with different risk preferences.

  • • The authors introduce a procedure for minimally modifying scenarios to render them consistent with one’s prespecified views about their probabilities of occurrence.

  • © 2020 Pageant Media Ltd
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The Journal of Portfolio Management: 46 (4)
The Journal of Portfolio Management
Vol. 46, Issue 4
March 2020
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Enhanced Scenario Analysis
Megan Czasonis, Mark Kritzman, Baykan Pamir, David Turkington
The Journal of Portfolio Management Feb 2020, 46 (4) 69-79; DOI: 10.3905/jpm.2020.1.125

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Enhanced Scenario Analysis
Megan Czasonis, Mark Kritzman, Baykan Pamir, David Turkington
The Journal of Portfolio Management Feb 2020, 46 (4) 69-79; DOI: 10.3905/jpm.2020.1.125
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  • Article
    • Abstract
    • STATISTICAL PROBABILITIES OF PROSPECTIVE SCENARIOS
    • CASE STUDY (DECEMBER 2018)
    • SCENARIO MODIFICATION
    • CONCLUSION
    • ADDITIONAL READING
    • ENDNOTES
    • REFERENCES
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