To VaR is Human
Originally appeared in the June 2009 Edition of Journal of Risk (Defunct).
Risk management is relatively simple in its essence: what is the probability of an event occurring, and, if it happens how badly will it hurt? However, if we consider how we estimate probabilities and losses, the answers to these seemingly simple questions become complicated very quickly. To estimate the size of losses, risk managers have increasingly turned to valuation models, some of which are well entrenched and are taught as gospel at many MBA and CFA programs[1] despite their deficiencies. For probabilities, on other hand, we now rely heavily on statistics to make guesses at estimation. Unfortunately, though, the human brain is incapable of distinguishing probabilities of less than 1%, rendering the comprehension of rare events rather difficult.
For both probability and loss estimation, it is important to understand the limits of theory. Traditional engineers, who often use the same techniques, usually build the highways that fulfill their utility functions, with the full understanding that they may collapse during stress tests (like the ones in the Northridge earthquake in California in 1994). Interestingly, the engineers who have designed collapsed structures have not received much blame for their lack of insight, because it was understood that these structured would fail (eventually). One can’t stop…
