Value at risk

Value at risk (VaR) is a financial risk metric that estimates the maximum probable loss of a portfolio over a specified time horizon at a given confidence level. It is the canonical example of the ludic fallacy in practice: a metric that performs well in calm markets because calm markets resemble casinos, and fails catastrophically in crises because crises are not casino events. VaR models dominated pre-2008 risk management, creating the illusion that tail risk had been measured and contained. The model risk inherent in VaR is not that it miscalculates probabilities but that it treats the probability distribution as stable when the distribution itself is the variable. A more honest measure is expected shortfall, which asks not how bad can things get at 95% confidence but how bad is the average loss beyond that threshold.