For investors, risk is about losing money. Understanding how to measure Value at Risk (VaR) can help you build a portfolio that’s right for you and take you one step closer to your financial goals.
Whilst risk carries negative connotations, it’s very existence gives savers the opportunity to offset the negative impact of inflation and achieve their financial goals quicker. In fact, the biggest threat to you achieving your financial goals is that you don’t rationally evaluate the risk associated with your investment.
Volatility is the most popular measure of risk, but it has its limitations; volatility only measures movement in an asset price, for example, not its direction.
Using VaR to value your investments instead can help you adopt a more rational approach to risk, and enable you to build an investment strategy that’s right for you and your family.
How to measure finance risk
When posed with the option of hearing the good news or bad news first, many will opt for the bad – there’s something about scoping out the worst-case scenario that can ease nerves.
Described as the “new science of risk management”, Value at Risk estimates how much your portfolio could lose in value over a period of time. Of course, VaR will never guarantee you a return – it’s based on estimates, after all – but it is a reliable indicator of performance with at least a 95% accuracy.
If you want to work out how much you could lose on your investment, you need to know the time period, confidence level and a loss amount. For example, you might ask: What is the most I could lose, with 95%-99% level of confidence, over the next year in percentage terms?
An equity stock could have an annual Value at Risk of 5% with 95% confidence, for example. This means that the maximum you could lose over one year is 5%, with 95% accuracy.
How to calculate value at risk
There are several different techniques to calculating Value at Risk, the historical method, the variance-covariance method, and the Monte Carlo simulation.
The historical method organises historical returns from worst to best, and assumes the past will be repeated, whereas the variance-covariance method uses an average return and standard deviation to compare normal distribution curve against actual return data.
To execute the Monte Carlo calculation, analysts create a model of forecast returns and run a number of hypothetical trials from it.
Achieving financial goals
The Value at Risk model has been built to help investors better understand investments and define the losses we can expect. We all have financial goals we’re trying to achieve, whether it’s a holiday, your first-home, or seeing your children through university.
Understanding the risks associated with our investments means we can build portfolios that will help us achieve our goals in the least amount of time possible.
Risk is found everywhere, and can affect companies, industries and entire asset classes alike. But it can be difficult to define the risk associated with your investment – it might just be a feeling in your gut that you can’t shake.
Only when you’re able to properly quantify the risks can you understand what the most suitable investment solution is for you. The more risk you take with your money, the larger the potential return – but also the larger your potential losses.
Knowing how risk works and being able to name the different ways to measure it is one thing; building a portfolio that matches your investor profile is quite another – especially if you’re busy juggling the school run with your career and homework time.
At Moneyfarm you don’t have to. We use complex calculations like this to ensure your portfolio specifically matches your tolerance to risk. The hardest decision you have to make is when to invest, and with how much.