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Value at risk (and its blind spot)

Value at risk (and its blind spot)

A common gauge of “how bad is a bad day” — useful, but it hides the very worst.

In short

Value at Risk estimates the most you’d expect to lose on a normal bad day, at some confidence. It’s handy — but it says nothing about how ugly the rare, worse days get.

A “1-day 95% VaR of $1,000” means: on 19 of 20 days you shouldn’t lose more than $1,000. It’s silent about that 20th day.

VaRworst days ← returns → best days
VaR marks the edge of the bad tail — but ignores how deep the tail goes.

Because VaR ignores the size of the worst losses, researchers proposed “expected shortfall” — the average loss on the bad days beyond the VaR line — as a fairer measure.[1]

Like saying “the river is usually under 4 feet.” True most days — and useless during the flood that actually drowns the town.

Use VaR as a rough speed limit, but never as proof you’re safe. The losses that hurt most are exactly the ones it leaves out.

Where these numbers come from

Finisdom focuses on real worst-case drawdowns from history, which capture the deep-tail pain that a single VaR number can miss.

Next: position sizing & Kelly

Check your understanding

What does VaR fail to tell you?

Sources & further reading

  1. 1.Artzner, Delbaen, Eber & Heath (1999) Coherent Measures of Risk — Mathematical Finance — Showed VaR’s flaws and motivated expected shortfall as a better risk measure.

Related

Fat tails and black swansDrawdowns, recovery, and timing

Tripped up by a word? Look it up in the glossary.

Learning only — not investment advice.