Do We Know How to Measure Investment Risk?
Joe Nocera is one of the most influential business journalists in America today. His piece in the New York Times offers a good summary of the debate that is currently raging on whether VaR (Value at Risk) is a good enough model for measuring investment risk and predicting the sort of financial meltdown we're currently in the midst of. Detractors point out that VaR, at best, only considers risks that occur within a probability of 99% (3 standard deviations). It does not consider the other 1% -- the outliers or unknown risks that Nassim Nicholas Taleb calls "fat tails" (the tails at either extremes of a bell curve) or "black swans". Taleb and others compare VaR to "an air bag that works all the time, except when you have a car accident!" Proponents of VaR acknowledge that, like democracy, VaR has flaws but is the best we've got. They remind us that, after all, it is VaR (along with good human judgment) that allowed Goldman Sachs to do a better job than others of sidestepping the mortgage crisis that precipitated the mess we're in.