Value at Risk for your Household
Obviously this has been a volatile year so far for every asset class, whether in technology, or crypto, or oil, or bonds, or the S&P 500, or even cash! This is the first time in decades, where if you have 100k saved in your bank account, you lose 10k a year in buying power by just keeping it there.
I came up with an idea while talking to a friend as she complained about how much she has lost in the markets over the last week. This isn’t investment advice, or “to the moon,” or “we’re doomed” kind of stuff, it’s just an important question I wanted to suggest, inspired by this conversation with her.
First the obligatory Wall Street setting. In big investment banks, the divisions that move assets around typically have traders and risk managers. The traders are the “producers” (ie they make money) so they have ownership of the revenue and all the prestige associated with the good times.
The risk managers are the worry warts, the Debbie Downers. They constantly analyze how much could go wrong with the asset positions and complicated derivatives transactions that the traders have engaged in. But they’re the people you need in situations of high volatility.
The cycle is almost always the same. Typically when times are good, the traders / producers are in charge, and the risk managers are looked down upon as unnecessary naysayers. When things collapse (such as the dot com bubble in the early 2000s, the housing bubble in 2008, and arguably now in 2022) then the traders get fired and the risk managers take over.
Risk managers serve an important role that is undervalued, in my view. They’re the ones that ask the uncomfortable worst case scenario questions such as, if Vladimir Putin detonates a nuke ahead of Russia’s Victory Day this weekend, and the market craters another 25%, where do we stand?
This is an important exercise, even beyond the context of a Wall Street trading desk. So in a family household context, ask the question if your portfolio (stocks, real estate, crypto, etc.) collapsed 25% over the weekend, what practical changes would be necessary?
What’s a little unsettling to me is that a lot of my friends, if they did that risk analysis, would realize their lives would be totally different. They’d have to change jobs, add jobs, or start working again, reassess where they live and how they live, etc. That’s an indicator that you might want to lower your exposure to speculative financial assets.
If you find yourself even unwilling to consider such an extreme scenario, well, haha, this is why they created the dedicated risk manager job. It’s not fun. You have to force yourself to actually map out what happens.
And if the answer bothers you too much? It might be time to re-manage your risk.