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Why Value at Risk (VaR) ‘cannot possibly work’
Mario Livio
Why can you understand this sentence: ‘How cmoe yuor bairn is albe to udnertsnad tihs snetnece eevn tghouh olny the frist and lsat ltetres of ecah wrod are crreoct ?’. Because of innate pattern recognition, that’s why. And here’s why it’s dangerous in investments.
According to global risk consultancy CheckRisk, humans’ desire to recognise patterns and symmetry tend to “con” us. “The only way to avoid this trap is to look outside of the VaR box, the problems of symmetry, and to use tools that may help in reining in our predispositions,” CheckRisk says in its latest client note “An early warning risk system is indispensible for any investor wishing to take advantage of and/or avoid risk.”
CheckRisk says that short-term risk is decreasing but long-term risk is increasing. The client note says: “To be clear the short term, meaning six months, outlook is benign given the recent sell-off which we forecast in April of this year.
“The longer term into 2016 is looking tougher, and we are mainly concerned with the period 2017 to 2020 for financial market risk. The long-term risk outlook is dependent on two principal risk factors: inflation and global GDP growth. These two risk factors are influenced by a whole host of others but unless inflation and global GDP growth accelerate it is clear that the burden of debt on the world will at some stage become too much.”
The problem for humans is that risk appears to us as a non-linear and asymmetric force for most of the time, which is the main reason that VaR as a system for predicting risk “cannot possibly work”.
The search for patterns and symmetry in financial markets may well be alchemy,” CheckRisk says. “Technical analysis, with the possible exception of relative strength indicators, flow of funds data and momentum indicators, are for the most part pattern recognition and subject to all of the biases and failings we mention. A technical pattern does not predict the future.”
The consultancy quotes scientist Mario Livio’s 2005 book, “The Equation that Couldn’t be Solved”: “Because our brains are so fine tuned to detect symmetry, is it possible that both the tools that we use to determine the laws of nature and indeed our theories themselves have symmetry in them partly because our brains like to latch onto the symmetric part of the universe and not because it’s the most fundamental thing?”
