# Value At Risk (VAR) Limitations and Disadvantages

## VAR is popular and has both advantages and limitations

**Value At Risk is a widely used risk management tool**, popular especially with banks and big financial institutions. There are valid reasons for its popularity – using VAR has several advantages. But for **using Value At Risk for effective risk management** without unwillingly encouraging a future financial disaster, it is crucial to know the **limitations of Value At Risk**.

## Value At Risk can be misleading: false sense of security

**Looking at risk exposure in terms of Value At Risk can be very misleading.** Many people think of VAR as “the most I can lose”, especially when it is calculated with the confidence parameter set to 99%. Even when you understand the true meaning of VAR on a conscious level, *subconsciously* the 99% confidence may lull you into a **false sense of security**.

Unfortunately, **in reality 99% is very far from 100%** and here’s where the **limitations of VAR** and their incomplete understanding can be fatal.

## VAR does not measure worst case loss

99% percent VAR really means that in 1% of cases (that would be 2-3 trading days in a year with daily VAR) the loss is expected to be greater than the VAR amount. **Value At Risk does not say anything about the size of losses within this 1%** of trading days and by no means does it say anything about the **maximum possible loss**.

The worst case loss might be only a few percent higher than the VAR, but it could also be high enough to liquidate your company. Some of those “2-3 trading days per year” could be those with terrorist attacks, Kerviel detection, Lehman Brothers bankruptcy, and similar extraordinary high impact events.

**You simply don’t know your maximum possible loss ****by looking only at VAR. It is the single most important and most frequently ignored limitation of Value At Risk. **

Besides this false-sense-of-security problem, there are other (perhaps less frequently discussed but still valid) **limitations of Value At Risk**:

## Value At Risk gets difficult to calculate with large portfolios

When you’re **calculating Value At Risk of a portfolio**, you need to measure or estimate not only the return and volatility of individual assets, but also the **correlations** between them. With growing number and diversity of positions in the portfolio, the difficulty (and cost) of this task grows exponentially.

## Value at Risk is not additive

The fact that **correlations between individual risk factors enter the VAR calculation** is also the reason why **Value At Risk is not ****simply**** additive**. The VAR of a portfolio containing assets A and B does not equal the sum of VAR of asset A and VAR of asset B.

## The resulting VAR is only as good as the inputs and assumptions

As with other quantitative tools in finance, the result and **the usefulness of VAR is only as good as your inputs**. A common mistake with using the classical *variance-covariance Value At Risk method* is **assuming normal distribution of returns** for assets and portfolios with non-normal skewness or excess kurtosis. Using unrealistic return distributions as inputs can lead to underestimating the real risk with VAR.

## Different Value At Risk methods lead to different results

There are several alternative and very **different approaches** which all eventually lead to a number called Value At Risk: there is the classical **variance-covariance parametric VAR**, but also the **Historical VAR method**, or the **Monte Carlo VAR approach** (the latter two are more flexible with return distributions, but they have other limitations). Having a wide range of choices is useful, as different approaches are suitable for different types of situations. However, different approaches can also lead to very **different results with the same portfolio**, so the representativeness of VAR can be questioned.

## So many problems… should I still use VAR?

You have seen **several serious limitations of Value At Risk** in this article and you might be thinking of never using VAR (again). However, Value At Risk can be useful, as long as you **keep its weaknesses in mind and don’t take VAR for something it isn’t**.

Value At Risk should be one little piece in the risk management process and **it must be complemented with other tools**, especially those taking care of that 1% worst case area, which VAR virtually ignores. **As long as you don’t let VAR become a false sense of security, it can be very helpful.**