Understanding Value-at-Risk and Your Loss Potential

One of the most important things that can affect your portfolio is the amount of risk you’re willing to take on. Some investors go all in to get big returns, while others try to preserve as much capital as they can.

How much risk you’re willing to tolerate is up to you.

There are several ways to figure out whether there’s too much risk in your portfolio. One way to do that is by calculating value-at-risk — or your portfolio’s loss potential.

Erika Taught Me

  • Value-at-risk is a way to calculate your portfolio's risk by examining how much it may lose over a period of time.
  • VaR can be used to evaluate the risk of individual assets within a portfolio as well as the entire portfolio itself.
  • Risk tolerance is a spectrum that varies based on individual goals and investing time horizon.

. . .

What Does Value-at-Risk Mean?

Value-at-risk (VaR) is a data point that tells you how much your portfolio could lose over a specific period. It isn’t how much your portfolio will lose — rather, VaR measures how much it could lose. 

VaR can be represented by a dollar amount or a percentage. That figure demonstrates the probability of loss within your portfolio. It allows you to calculate risk so you can compare different scenarios and see the amount of risk you’re willing to take on.

VaR example

Let’s say you’re in your 20s and just starting your career. Your portfolio is worth $10,000 and is 100% allocated to stocks like Amazon and Tesla. 

Let’s say the VaR for this portfolio is 5%. This means your portfolio has a 95% chance of losing 5% of its value. Put another way: your portfolio could lose up to $500 in a given day.

Someone in their 20s might be okay with that happening because they have the rest of their career to keep investing. 

However, someone who’s retired might think a $500 loss is too much to risk. They might reallocate their assets to prioritize more conservative assets — like bonds — rather than sinking all of their money in stocks.

The point of VaR is to understand your risk exposure. As you get older and move closer to retirement, you can identify risks in your portfolio and take steps to mitigate those risks.

Pros and Cons of Calculating Value-at-Risk

While VaR can help you make investing decisions, it isn’t perfect. 

Pros

  • VaR is a simple number that can be used to compare the risk of different assets within a portfolio.
  • Many investing tools calculate VaR for you.

Cons

  • Some calculation methods are too complex to do by hand.
  • VaR doesn’t account for outlier events.
  • It’s impossible to eliminate all risk when investing.

READ MORE: How Much Can I Afford to Invest?

How To Calculate Value-at-Risk

There are three ways to calculate value-at-risk:

  • Historical
  • Variance-covariance
  • Monte Carlo

Fortunately, a lot of investing software calculates VaR for you. A tool like Portfolio Visualizer includes VaR and allows you to evaluate different asset allocations for yourself. 

Historical method

The historical method looks at your prior returns history. It ranks your returns from worst losses to best gains. 

While the past can’t predict the future, the historical method looks at the past to give you an idea of what could happen in the future.

Variance-covariance method

Variance-covariance looks at the distribution of returns according to an average standard deviation. 

This VaR calculation uses statistical modeling to calculate your risk exposure and assumes no anomalies in the distribution of returns. 

Because this method doesn’t account for outlier events, it can generate an inaccurate VaR.

Monte Carlo method

The Monte Carlo method is the most complex way for beginners to calculate VaR. 

It uses a computer simulation that forecasts projected returns across several possibilities. It assesses the chance of a loss occurring and its impact on your portfolio. 

This is something professional investors and large firms do when there’s a lot of risk to consider in a portfolio.

READ MORE: 25 Investment Terms to Know If You’re a Beginner Investor

What is the Formula for Value-at-Risk?

If you want to calculate VaR by hand, the historical method is the easiest. You can use this formula to calculate it:

Return = Price t – Price (t-1) / Price (t-1)

First, calculate the daily return of your portfolio over a set period. 

Then, list each day’s returns from smallest to largest. For a 95% confidence VaR, look for the value where 5% of the worst losses lie below. 

For example, if you calculate 100 days’ worth of returns, you’ll look for the fifth worst return on your list. This is your VaR.

To determine your portfolio’s loss potential, multiply your VaR by the value of your portfolio. 

For example, if your portfolio is $10,000 and the VaR is 2%, your portfolio could lose $200 in a day. 

By calculating VaR, you can see whether or not there’s too much risk in your portfolio and take action to adjust it.

How to Use VaR to Invest

Let's look at a hypothetical example to show how to use VaR to make investment decisions.

Jim is 22 and has invested $10,000. His portfolio consists of 80% stocks and 20% bonds. 

The VaR for his portfolio is 2%, which means there’s a 95% confidence level that he won’t lose more than $200 in a single day.

That’s an acceptable level of risk for Jim, but his stock allocation is too heavily invested in high-risk growth stocks. He wants to diversify by adding more dividend stocks to his portfolio. 

He’s evaluating stocks that have the following VaRs:

  • Stock A: 1.5%
  • Stock B: 3%
  • Stock: 1.2%

Given that Jim’s overall portfolio has a VaR of 2%, he doesn’t want to take on more risk than that. Based on the VaR of the new dividend stocks he’s considering, he eliminates Stock B. 

In this scenario, VaR can be a useful metric for eliminating assets with too much risk. You can reduce unnecessary risk in your portfolio by eliminating those assets and reinvesting in assets with lower VaRs. 

READ MORE: Why It's Important to Rebalance Your Portfolio

How Much Loss Potential Is Too Much for You?

Determining how much loss potential is too much depends on several factors.

  • Risk tolerance: Someone who is okay with having their portfolio all in stock will have a different risk tolerance than someone who wants to earn predictable income. This distinction comes down to how much you’re willing to lose if stock prices tank.
  • Time horizon: A younger investor might have a higher risk tolerance because they have more time in the market. As you get older, you’ll want to take on less risk to protect your nest egg.
  • Income: If you have a lot of extra money burning a hole in your pocket, you might not be too concerned about losses. Someone who doesn’t have much to invest with, on the other hand, might be more risk averse.

While no one can eliminate risks, there are things you can do to mitigate them. One way to do this is to be intentional about how you allocate assets within your portfolio.

Knowing the difference between avoidable and unavoidable risks is a good place to start. 

  • An avoidable risk is putting all of your eggs in one basket, such as investing in a single stock like Zoom. During the pandemic, Zoom’s stock soared. But after workers started going back to the office, share prices dropped.
  • An unavoidable risk is something you can anticipate but can’t really avoid. The 2008 financial crisis resulted from policies and macroeconomic conditions that most investors couldn’t plan for. While the economy has recovered since then, many people saw tremendous losses.

Once you understand the factors within your control, compared to those outside your control, you can use VaR to decide how to structure your portfolio. 

VaR applies to individual assets as well as your whole portfolio. You can look at the individual VaR for specific assets to include those with the least risk. This can help you diversify risk across your portfolio, reducing its impact when a downturn happens.

FAQs

Can VaR be negative?

VaR is typically reported as a positive number — the amount of money your portfolio could lose in a given period — but it is negative when calculated. 

What is the difference between value-at-risk and expected shortfall?

Both value-at-risk and expected shortfall can help you understand risk when investing. 

  • Expected shortfall (also called conditional value-at-risk) looks at averages to show how severe a loss could be. 
  • VaR looks at the possibility of loss across your portfolio within a specific period. 

Put another way, expected shortfall looks at risk beyond the value established by VaR. This can be used to stress test a portfolio to determine how much of a loss it could be hit with during a severe downturn.

TL;DR

While value-at-risk doesn’t tell you how much your portfolio will lose, it can tell you how much you might lose. It’s a hypothetical number that’s calculated based on past performance or possible future scenarios.

You can use VaR to determine how much risk you’re willing to take on and to rebalance your portfolio if you feel like your portfolio is getting too risky in one area.

For more investing insights, check out these episodes of the Erika Taught Me podcast:

Latest Articles
A smartphone screen showing a graph of investments moving upwards

How To Use Webull: A Beginner’s Guide to Setting It Up

Stressed woman holds bank cards in her hand.

Should I Get a Personal Loan to Pay Off Credit Card Debt?

Young woman with her luggage at an international airport

Travel Hack: Save On Baggage Fees With a Media Pass

Woman in a downtown setting, surrounded by buildings and looking at her phone.

Fundrise Review: Invest in Real Estate for $10

Best Life insurance Companies in June 2024

Related Articles

Compare To Other Cards

Best Offers From Our partners

Reward rate

Welcome bonus

Annual fee

Regular APR

Recommended credit

Author picture

I'm an award-winning lawyer and personal finance expert featured in Inc. Magazine, CNBC, the Today Show, Business Insider and more. My mission is to make personal finance accessible for everyone. As the largest financial influencer in the world, I'm connected to a community of over 20 million followers across TikTok, Instagram, YouTube, Facebook and Twitter. I'm also the host of the podcast Erika Taught Me. You might recognize me from my viral tagline, "I read the fine print so you don't have to!"

I'm a graduate of Georgetown Law, where I founded the Georgetown Law Entrepreneurship Club, and the University of Notre Dame. I discovered my passion for personal finance after realizing I was drowning in over $200,000 of student debt and needed to take action-ultimately paying off my student loans in under 2 years. I then spent years as a corporate lawyer representing Fortune 500 companies, but I quit because I realized I wanted to have an impact; I wanted to help real people and teach them that you can create a financial future for yourself.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.