What’s Your Personal VaR?

By Clifford Rossi

SMITH BRAIN TRUST – The recent steep declines in global financial markets driven by uncertainty over a pandemic spread of the Covid-19 virus naturally have individual investors worried about their investment portfolios.

Managing your own investment risk like a bank can provide a way to quantify your appetite for risk under a wide range of outcomes in a consistent and easily understood manner.

The largest and most complex commercial banks apply value-at-risk, or VaR as it is known, as a technique to establish the outer bounds of risk for their institutions. VaR describes the worst portfolio loss a bank is willing to take over a prescribed time horizon and confidence level. For example, on a $1 billion portfolio of assets, the bank might establish its VaR limit as the 99th percentile worst trading loss over a single day.

If on a $1 billion portfolio that loss is $50 million, then that becomes the bank’s upper limit for daily losses. If the portfolio were to breach that limit on any given day over time, it would provide a signal to management that the portfolio is too risky compared to the VaR limit and actions such as rebalancing the portfolio would need to be taken.

Translating that to individual investment portfolios requires having a distribution of losses in your portfolio based on a simulation of market and macroeconomic factors over time.

There are a variety of free tools on the market today for small investors that will run your portfolio through its simulation model under thousands of scenarios and generate a report showing your portfolio’s value at various percentiles over time. These tools are meant to inform investors of how their portfolio might perform over the long haul under a range of good, bad and average conditions. However, with a slight twist, these models and results could be used to directly establish your own risk appetite.

Today, most financial advisors when meeting with a client for the first time will have them fill out a list of questions to ascertain the risk profile of that client. It helps guide the process as to what allocation the client’s portfolio is best suited for their risk tolerance. Imagine that in addition to this, you had the ability to set your own personal VaR. What might that look like?

First, ask yourself what is the maximum loss you are willing to tolerate over some specific time period of interest.

Let’s assume we have a portfolio made up of 70% stocks and 30% bonds indexed to the market. Based on your circumstances, you decide to set your time horizon at one year. And you might start off the exercise by assuming a 99% level of confidence.

Let’s now assume that this portfolio is currently valued at $250,000. If the 99% level of losses over the next year turns out to be $125,000, you now have a financial “yardstick” by which to now decide whether a loss that large (albeit extreme) is tolerable for you. You have the ability to change both the time horizon and level of confidence in zeroing in on what number is a worst loss outcome for your portfolio. If you are uncomfortable with losing as much as $125,000 or more 1% of the time in a year, it might force you into reviewing your portfolio mix to dial-back the maximum loss you are willing to take.

Once the VaR is set, you can run your portfolio through the VaR exercise (perhaps no more than quarterly) in order to ensure that the portfolio remains within your own risk limits.

Understanding an investor’s appetite for portfolio risk has been an essential part of the financial planning process for years. Adapting today’s financial planning simulation models to incorporate VaR analyses can greatly assist investors in quantifying their risk tolerance and to shape their portfolios in a manner to withstand significant market upheavals without losing sleep during turbulent times.

Clifford Rossi is Executive-in-Residence and Professor of the Practice at the University of Maryland’s Robert H. Smith School of Business. He spent 25 years in banking and government. His most recent position was Managing Director and Chief Risk Officer for Citigroup’s Consumer Lending Group, where he was responsible for overseeing the risk of a $300+B global loan portfolio.