What is an Expected Shortfall?

An expected shortfall is an idea that is commonly utilized within the process of financial risk management to determine the amount of risk associated with a financial portfolio as it is presently constituted. The idea is to be aware of how the assets contained in the portfolio will perform if certain events occur within the marketplace or within the operational structure of the companies issuing those investments, and identify the likelihood of experiencing some sort of loss on one or more of those assets. By anticipating the shortfall, it is possible to assess the overall impact on the portfolio and make an informed decision of whether to hold onto those assets, or sell them off before the expected decrease in value should take place.

There are several different names for this process in common use around the world. In some quarters, an expected shortfall is commonly referred to as an average value at risk. The process may also be known as an expected tail loss or a conditional value at risk. By any name, the idea is to evaluate the return potential of each asset in the portfolio, with particular attention to the possibility of incurring losses with one or more of those assets.

Along with identifying the possibility of risk, an expected shortfall also makes use of different calculations to determine how much of a shortfall is likely to take place, given a specific set of variables. Here, the idea is to determine the impact of specific events on the portfolio’s value, making it easier to decide whether to hold onto the current set of assets, or to make some trades that alters the portfolio in some manner. This also involves having some idea of how long a given asset is likely to continue dropping in value once the decline begins. If the projection is that the shortfall will be slight and will be corrected within a reasonable period of time, the investor may choose to do nothing. Should the indication be that the shortfall is likely to continue for some time, the investor may take steps to minimize the impact of that loss on the portfolio, either by reducing the number of shares held in favor of assets that are projected to experience growth during the same time frame, or sell off the asset entirely.

As with any type of financial tool, assessing an expected shortfall relies on the use of reliable data and the proper interpretation of that data. Failure to do so could ultimately cost an investor more in terms of portfolio value if incorrect projections regarding the shortfall are developed than if the assessment was never made. For this reason, it is important to make sure the expected shortfall is based on solid factual information that is verified through a reliable source, and not on unfounded speculation.