Scenario Tree for Securities Investment
A scenario tree structures investment decisions under uncertainty by mapping out combinations of choices (high-risk stocks, medium-risk stocks, low-risk bonds) and future developments (war/peace, prosperity/depression) to avoid overlooked scenarios.
THE IDEA
EXERCISE 19 Securities Investment I
Construct a scenario tree to structure the following problem:
Your company is planning to invest a goodly sum of money in stocks or bonds. Three options are under consideration: high-risk, high-return stocks (HI/HI); medium-risk, medium-return stocks (MED/MED); and bonds assumed to have no risk and low returns for this exercise (NO/LOW). Looking ahead, the company foresees four major developments that will affect the viability and profitability of each of these three investment opportunities: war or peace, and prosperity or depression.
BEFORE CONTINUING, DRAW YOUR SCENARIO TREE.
The solution to Exercise 19 is one rendition of the tree. I’m always amused by people who reject using such a structuring technique on the grounds that it’s too complicated. Do they mean to say that analyzing this problem in their heads is less complicated? The truth is, as I mentioned earlier—and it bears repeating—the human mind doesn’t like to be structured. It prefers to operate as a free spirit, jumping compulsively from one thought to another… just messing around. The inevitable result is that some of the scenarios depicted in the tree above would never be considered, and that is precisely the deficiency in human problem solving that the structuring techniques in this book remedy.
The source discusses evaluating the investments in Exercise 42 in Chapter 14. This exercise concerns constructing the tree: the branches make the stated combinations visible, but choosing an investment also requires estimates of returns and risks.
When to use it
Evaluating investment portfolios under different economic conditions
Assessing business strategies when faced with political and economic uncertainties
Planning project risk management by considering multiple potential outcomes
Comparing product pricing strategies given uncertain market response
FROM THEORY TO EVERYDAY LIFE
In practice
Investment Scenario Tree
A company compares high-risk high-return stocks, medium-risk medium-return stocks, and bonds assumed risk-free within the exercise. It maps each option against combinations of war or peace and prosperity or depression. The tree displays the possibilities defined by those assumptions; it does not cover every possible future.
Product Launch Decision
A tech startup considers low, medium, and high prices under different competitor responses and rates of market adoption. A scenario tree shows the combinations to evaluate. The team must supply estimates of probabilities and outcomes before using the tree to compare prices.
A MOMENT TO REFLECT
Put it to work.
Why might people resist using structuring techniques like scenario trees even though they can reveal overlooked scenarios?
Think of a recent decision you made without a structured approach. What scenarios might you have missed?
How does the scenario tree help in comparing different investment options across multiple future states?
Often confused with
CONTINUE THE CONVERSATION
Source texts
- The Thinkers Toolkit by Morgan D Jones