Don’t blame it on VaR

NY Times ran an article Risk Mismanagement:

VaR uses this normal distribution curve to plot the riskiness of a portfolio. But it makes certain assumptions. VaR is often measured daily and rarely extends beyond a few weeks, and because it is a very short-term measure, it assumes that tomorrow will be more or less like today. Even what’s called “historical VaR” — a variation of standard VaR that measures potential portfolio risk a year or two out, only uses the previous few years as its benchmark.

Nonsense. VaR is an innocent and useful mathematical construct, completely independent of the distribution or the model used. It can be as simple as subtracting variance from the mean to penalize for the risk of a distribution. Don’t throw the baby (VaR) out with the bathwater (dubious VaR practices).

The real failure of risk management was in the bad short-tailed models (that underestimated the probability of a default) that they fit in a bad way (overfitting to a small amount of one-sided historic data, without using priors that would include the possibility of a disaster).

But even once these problems are fixed, economy will still be a feedback system, not something pretty, simple and linear. Let’s hope for a marriage of statistical modeling with systems and complexity theory. In the meantime, I’ll hope for using more common sense based on substance and less mathematics based on arbitrary metrics. This would help prevent disasters in the first place.