With the advance of technology, incorporating the widespread value at risk/VaR analysis into portfolio risk management process is easy these days. However, as discussed in my previous article, not all retail investors realize this fact and tend to overlook useful tools that professional asset managers rely on. By no means is VaR the Holy Grail as its flaws have been well documented, but having a simple statistical measure to quantify market exposure proves beneficial.
In contrast to casino gambling, financial investments are not win all / lose all type of bets. Their value fluctuates on a daily basis and it is important to know the magnitude of those swings. This is where VaR comes in. Not getting into definition and analysis of VaR itself, I would like to demonstrate how this statistical tool can help investors understand their risk better.
To keep things simple, I will refer to a market standard 99% one day VaR throughout this article. To begin with, let's assume a hypothetical investor holds a simple portfolio containing only two assets: S&P 500 Low Volatility ETF (NYSEARCA:SPLV) and Gold ETF (NYSEARCA:GLD), with equal allocation to each position. A quick check of such a portfolio on one of the freely available investor resources provides the following risk statistics, based on one year data:
The figures above suggest a few important insights:
- Individual SPLV VaR is 1.3%. This means that an investment in this security can be expected to lose no more than 1.3% on 99 out of 100 days.
- Individual GLD VaR is 2.0% - substantially higher than that of SPLV.
- Combined portfolio VaR is 1.2%, which is lower than VaR readings for each component individually. This risk reduction is purely a result of a diversification effect as SPLV and GLD are little correlated.
- The hypothetical portfolio is 33% less risky than S&P 500 ETF (NYSEARCA:SPY) (1.2% vs 1.8%).
Attaching some dollar values, if our investor's portfolio is $100,000, it can be expected to lose no more than $1,200 on 99 out of 100 days. Of course, this is a simplified version of analysis and changes in volatility regime could easily impact VaR values. Nonetheless, knowing how one's portfolio compares to the broader market and an indication of what amounts are at stake will only help investors feel more comfortable with their portfolio choices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.