Do you know how risky your portfolio is? How do you define the riskiness of your portfolio anyway? If you are managing your own portfolio of securities, it is always a good idea to have “worst case” scenarios. If I told you, that your portfolio could lose 40% of its value tomorrow, would you still keep it?
Value at Risk
As you see above, it’s best to have some metrics about your portfolio to help you gauge the level of risk that match your own risk tolerance. A very popular tool exactly for that is VaR, which stands for Value at Risk. In simple terms, VaR estimates the probability for a given loss in the portfolio.
VaR can be defined for other periods as well. For example, if we say that the VaR for a 5 day period is $5 Million, at a 95% level, we mean that the probability that our portfolio will lose at the next 5 days more than $5 million dollars, is less than 5%.
Computing VaR
The million dollar question is of course, how do we know the probability to lose a certain amount of money on our portfolio anyway? For that we’ll have to make certain assumptions. We’ll have to assume that past returns have a certain probability distribution and hence, we are essentially assuming that past performance tells us something about the future. The easiest method of all, though controversial, is to assume that returns have a normal distribution and to estimate the future returns with historical data.
If you are not sure what is a normal distribution, then you might want to google that before proceeding. If you don’t want to do that either, don’t worry, since I will supply at the end of this post a program that does all the computing for you.
In Part II, I’ll give you the mathematical formulas behind the ideas, and supply you with a program that will do the calculation for your portfolio.
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