If you are a corporate finance executive or financial professional it is very likely that you now face more sources of uncertainty and risk than ever before. While financial markets have created numerous products to help mitigate financial risks, risks continue to multiply and continue to become strategic and macro-level events.

One effective tool for coping with these myriad and multiplying uncertainties is scenario planning. Beyond its traditional uses within the corporate finance realm, scenario planning is also a powerful tool for investors trying to discount the uncertain future and yet craft a winning investment thesis.

To chart the current state of the art in scenario planning, I interviewed Jim Butcher, the founder and chief executive officer of Entegra Partners. Butcher’s firm is a boutique consultancy focusing on strategic and scenario thinking, planning, and leadership. Jim was formerly a managing director at Morgan Stanley (MS) where he led their Strategic Engagement Group, which helped the firm and its business units think more broadly about potential risks, opportunities, and responses.

CFA Institute: What are some of the advantages of scenario planning over other corporate tools designed to cope with the world’s dynamism?

Jim Butcher: There are very few good approaches to thinking about uncertainty and how best to cope, let alone, find the best investment strategies forward. Forecasting techniques that rely on quantitative metrics are limited since many risks, such as the consequences of an EU debt crisis, can’t accurately include intangibles like politics or investor hedging. For decades scenario planning has been one of the best tools for addressing the many uncertainties companies and investors face since it attempts to include both quantitative and qualitative dimensions to better reflect possible business futures and to help one navigate these possible futures better and with more success.

Please share with us the difference between uncertainty and risk.

University of Chicago professor Frank Knight was one of the first to make a distinction between “risk” and “uncertainty” in his book Risk, Uncertainty and Profit. Risk is a word that best describes situations where the distribution of possible outcomes is either known or can be estimated with some confidence.

It sounds like what you are saying is that risk is a concept best applied where one typically would use traditional statistical methods.

Yes.

What sorts of situations warrant “risk” management tools?

Generally, when probabilities can be assessed and a range of choices can be aggregated and analyzed statistically.

Now, by contrast, what is uncertainty?

Uncertainty is about a potentially unlimited set of choices or outcomes and frequently pertains to a specific situation.

And what events would warrant “uncertainty” management tools?

The Euro crisis for one. It’s clearly better today, or at least the prospect of some resolution is more in a positive direction than it was in early December. But if you think back to some of the news headlines recently, many analysts weren’t sure the Euro would even survive. Talk about an incredible range of possible outcomes!

In that example, it would not be surprising if many investment managers exposed to the EU became more conservative since probabilities are next to impossible to assign. So a tool like scenario planning would be more useful.

Absolutely, but here’s an important point from having done this work for over twenty years: What comes out of thinking hard about how the Euro crisis scenarios “might” unfold with a group of smart, experienced people is that you find some risks are not being priced into the market, resulting in trading, hedging, and investment opportunities implicit on the downside and upside.

For example, back in 1997, we did Japan scenarios with a Morgan Stanley team, and rather curiously, the team couldn’t find a future scenario where there was an upside. At the time, MS was considering an investment, and the team decided, based on this work, not to make an investment. In contrast, another bank did make a similar investment and lost $1.2 billion. More importantly, the lack of a plausible upside scenario totally changed MS thinking about Japan’s economy, and they started focusing on a completely different strategy which led to much improved revenue and investments in Japan. This example illustrates what one senior MS banker often said about scenarios: “They change my center of perception and open up some free options.”

That’s a great story and example. But some investment managers may discount scenario planning. Since it can’t accurately predict the future, they may still feel more comfortable with assigning probabilities.

Boy, wouldn’t it be nice to have a crystal ball and be 80%+ right with your investment strategies! I’ve been reading recently about hedge fund returns dropping back into beta, 5% range over the last year and I wonder about their traditional analytical approaches creating “more of the same” kind of thinking and investment strategies. Thinking back over the years of doing scenario planning I can probably think of between 10-15% of the created scenarios that were absolutely, precisely what happened (from over 120 plus scenario planning projects). But, that’s not the point. The real value of scenario planning is more dynamic and powerful insights that give more options and better strategies. For example:

1. The future may be uncertain, but it is NOT unknowable. If you dig a bit and do good research you know a tremendous number of the big uncertainties and trends out there. I would argue you just don’t have a good framework or a structured way of thinking of the possible outcomes and insights.
2. Scenario planning is about changing minds, opening up some new neural pathways to see new insights where others only see the same. A friend of mine recently told me about some of his new research into private equity and how there are only a few consistent firms that year after year crank out impressive returns. I find myself wondering: what are they doing differently than the others?
3. Finally, going back to my earlier example about Japan, if you come up with some key insights that others in the market don’t have, you have a tremendous competitive advantage. One of the first examples that Royal Dutch Shell did with scenarios back in the late 1970s was seeing the possibility of an oil cartel emerging in one of the scenarios, what we now know as OPEC By tracking early monitoring signals and acting on the emergence of OPEC developing, they moved from number eighteen in world market share for oil companies to number two in two short years.

Look for part two of this engaging interview with Jim Butcher on 6 February 2012.

Originally published on CFA Institute’s  Enterprising Investor.