February 17, 2010
What is the most I can lose on this investment?
This is a question that almost every investor who has invested or is considering investing in a risky asset asks at some point in time. Value at Risk tries to provide an answer, at least within a reasonable bound. It gives the likelihood that a portfolio will suffer a large loss in some period of time, or the maximum amount that you are likely to lose with some probability (say, 99%).
It finds this by:
But things are not as simple as that. Real markets don’t go by statistics or rules of probability. You must read this article by Joe Nocera which talks about VaR in light of the sub-prime mortgage crisis.
Here is an interesting excerpt:
"At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans [unlikely events] all the easier to ignore. All the incentives, profits, compensation, glory; even job security went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too."
So, here is what’s wrong with the approach:
Is VaR the Right Methodology?
In many situations, VaR may not be the correct risk-management methodology. If we pick a specific loss such as $1 million, VaR allows us to estimate how often we can expect to experience this particular loss. For example, using VaR we might estimate that we will lose at least $1 million on one trading day in 20, on average. During some 20-day periods, we might lose less than $1 million. During other 20-day periods, we might lose more than $1 million on more than one day. VaR tells us how often we can expect to experience particular losses. It doesn’t tell us how large those losses are likely to be.
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