📊Problems With Probabilities
How overconfident math geeks nearly destroyed the global financial system & in what scenarios might Expected Shortfall be a more appropriate measure than VaR?
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Problems With Probabilities
How overconfident math geeks nearly the global financial system
In "Naked Statistics" by Charles Wheelan, we are transported to a time when Wall Street's brightest minds, a band of overconfident math geeks set the global financial system teetering on the edge of disaster. These protagonists, wielding the double-edged sword of the Value at Risk (VaR) model, believed they had mastered the art of predicting the future.
Unraveling the Value at Risk (VaR) is essentially a tool used by investors to measure the risk of loss in their investments. Imagine you're planning to invest some money into a new business, but you're worried about how much you might lose if things don't go as planned. VaR helps by giving you a number, say $100, which means, "Based on past business performance, there's a very small chance (like 5% small) that you'll lose more than $100 over the next month."
It's like checking the weather forecast before a picnic to see how likely it is to rain and deciding whether to go ahead, postpone, or cancel based on the risk of getting soaked. So, VaR gives investors a way to gauge how stormy the financial weather might be, helping them make informed decisions on whether to proceed with their investment picnic.
Now, back to the geeks…
VaR was their crystal ball, promising to distill the complexities of market risk into a single, manageable figure. With this tool, the financial sorcerers of Wall Street ventured deeper into the realms of investment, their faith unshaken in the precision of their mathematical guardian.
However, their tale took a dark turn when unexpected monsters from the market's abyss reared their heads—the rare but catastrophic events VaR had overlooked. As the 2008 financial crisis unfurled its wings of chaos, the fallibility of their trusted model was laid bare, their fortress of numbers crumbled, and their world plunged into turmoil.
Wheelan’s recounting of this saga serves as a vivid reminder of the dangers of overconfidence in the mathematical models that promise to tame the unpredictable forces of the financial markets. It’s a cautionary tale that whispers the age-old wisdom: in the kingdom of risk and reward, humility and respect for the unknown are the true guardians against disaster.
In What Scenarios Might Expected Shortfall Be a More Appropriate Measure than VaR?
Everyday our Premium Subscribers send questions through our Wall Street Direct Line, and I recently received this question:
The saga of overconfidence among math geeks, which nearly capsized the global financial system, starkly underscores the limitations of traditional risk assessment tools like Value at Risk (VaR). In this context, Expected Shortfall (ES) becomes an indispensable beacon, shedding light on the shadowy depths of risk that VaR fails to illuminate.
While VaR offers us a glimpse into the likelihood of financial storms, it doesn't measure how soaked our investments could get in the event of a downpour. This is where Expected Shortfall (ES) comes into play.
Unraveling the Expected Shortfall (ES)
Imagine you're saving up for a big vacation, and you've got two jars of money. One jar is pretty stable; you add the same amount every month, but there's a tiny chance it could break, losing some cash. The other jar is more unpredictable; it might suddenly crack and lose a lot of money, though this happens rarely. Expected Shortfall (ES) is like having a tool that tells you, "If one of these jars breaks, here's the minimum amount you should expect to lose, especially from the jar that could lose a lot.
Instead of just knowing there's a chance your jar might break, ES tells you how bad the damage could be with the worst breaks, helping you decide how to protect your savings better or maybe not use that risky jar at all. This way, you’re not caught off guard by how much you might lose and can plan your savings strategy more effectively.
ES's comprehensive scope makes it particularly apt for scenarios marked by extreme market volatility and the potential for severe losses—situations where VaR's threshold-based measurement falls short of capturing the full spectrum of risk.
In the strategic framework of the Alpha Hedge Strategy, where dynamic diversification and a nuanced understanding of market cycles are paramount, ES aligns seamlessly with our ethos of preparedness and adaptability.
This alignment is critical in environments where the fabric of the market is frayed by unforeseen crises or when the tail risks—those rare but devastating events overlooked by VaR—threaten the stability of our portfolio.
By integrating ES into our risk management practices, we're not merely responding to the market's currents; we're anticipating its storms, ensuring that our asset allocation and investment decisions are fortified against the kind of catastrophic losses that once brought the financial world to its knees. This forward-looking approach, informed by the depth of analysis offered by ES, ensures that our strategy remains robust, resilient, and responsive to the ever-evolving challenges of the financial markets.
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