Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

5.6 Portfolio Tools

Think of volatility and VaR as the standard quantitative risk measurement tools. They help us understand the size of the risk. But they don't tell us where the risk comes from or how we can alter it. They are flat in the sense of telling us the size but nothing about the composition. We need tools for understanding the composition of the risk—where it comes from and how we can change it.

There are two basic problems in understanding risk:

1. Risks combine in a nonlinear, often nonintuitive manner. Risks don't just add. Sometimes two risks add, sometimes they subtract. It's not obvious, without some work, how different risks will add or subtract.

2. For more than two risks, it becomes impossible to understand without quantitative tools to aid our understanding. A large portfolio can be so complex that we need simple, straightforward tools to help untangle the risk and point us in the direction of how to manage that risk. We need tools for drilling down to uncover the sources of risk.

Litterman (1996) expresses this well:

Volatility and VaR characterize, in slightly different ways, the degree of dispersion in the distribution of gains and losses, and therefore are useful for monitoring risk. They do not, however, provide much guidance for risk management. To manage risk, you have to understand what the sources of risk are in the portfolio and what trades will provide effective ways to reduce risk. Thus, risk management requires additional analysis—in particular, ...