This research is a collaboration between GIC, Windham Capital Management and State Street Associates. For the full research paper, please click on the “Save As PDF” button.
Constructing portfolios with scenarios in mind
Given today’s highly uncertain environment, scenario-based analysis and portfolio construction have gained huge popularity among institutional investors. As outlined in the new research paper “Portfolio Choice with Path-Dependent Scenarios”, we have developed a new systematic approach to scenario analysis that enables investors to consider their sequential impacts on portfolio risk and performance.
We illustrate the technique by evaluating alternative scenarios for the aftermath of the COVID-19 induced economic downturn. Extrapolating from relevant historical data, a U-shaped recession appears the most probable for the next 3 years with a 30% probability, followed by V-shaped recoveries at around 20% each, and 16% for a stagflation scenario. The least likely outcomes are a deep depression and W-shaped recession (see Figure below). As the COVID-19 crisis has been unprecedented in so many ways, agreeing on these results will be challenging. The key is to come up with an objective baseline and alternatives for discussion and debate.