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Systematic approach for an uncertain future

13 maggio 2014

Putting together a picture of possible future developments lies at the heart of every strategic investment decision. However, in a complex world it is impossible to predict the future.

The scenario analysis technique can help overcome such complexity, also within asset allocation.

Using a structured multi-stage process, LGT Capital Management develops portfolios for its clients which are robust under different financial market conditions. Besides the needs of investors, expectations of how financial markets will develop in the next few years always represent a starting point for strategic asset allocation. Given the extensive challenges and dangers posed to the global economic and financial system, there is a very wide range of conceivable future developments. Forward-looking methods such as scenario planning can be used to help ease the complexity of this difficult issue and enable a qualitative analysis of the future to be conducted. Such scenario building not only involves putting together a picture of how the future may look like, but draws up a number of possible future developments, replicated by a handful of representative scenarios. 

Systematic scenario approach

LGT Capital Management develops these scenarios in several steps. First, the factors that influence financial market developments are defined. Besides macroeconomic aspects, these include relevant political and social factors, such as political stability in Asia and energy consumption behavior. Here, it is vital not only to rely on one’s own abilities, but also to include academics and researchers from specific thematic areas, such as genuine experts on agriculture, the Asian political landscape and other highly specific financial topics.

Future scenarios are then modelled for the different factors defined. For example, three variants for a five to ten year time horizon can be assigned to the factor “energy prices”: sharply rising prices, moderately rising prices or moderately falling prices. This process is applied for all defined relevant factors, between 25 and 50 depending on the issue. This results in a number of different scenarios.

Although history does never repeat itself exactly, it can deliver important findings. Therefore, plausible scenarios can be drawn up based on past events together with certain adjustments made for current developments. But also new scenarios, such as the decoupling of the emerging markets or the debt crisis in the industrialized nations, emerge during the process. Finally, these scenarios are classified as either baseline or risk scenarios.

Qualitative is followed by quantitative

In a next step, quantitative data such as returns, risks and correlations are derived from the qualitative scenarios for a number of asset classes. An innovative optimization technique is then used to optimize the portfolio. This entails determining a risk-return-optimized portfolio for each scenario rather than using weighted returns for the different scenarios. Then, a robust portfolio is sought that exhibits resilience in all of the baseline scenarios, though it does not attain the maximum return in each individual environment. The risk scenarios are not directly included at the portfolio optimization stage. However, it is important to define observation points. If the view on the different scenarios changes or a new scenario is generated, the strategic asset allocation must be adjusted.

This structured process and the resulting, systematically thought through scenarios enable LGT Capital Management to put together tailor-made portfolios for long-term investors that robust under a variety of market conditions. This in turn leads to a successful, long-term investment policy, which can be supplemented by tactical investment decisions.

Download LGT Investorama

You find more information about our asset allocation strategy in the LGT Investorama. This quartely publication we can only show you depending on your country of domicile. To download this document onfrom our webpage "Market information" please go to “Domicile selection” first: LGT market information