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Expected Shortfall

Risk Management

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Expected Shortfall is an important metric that reveals information not included in Value at Risk. It’s also called Expected Tail Loss, Conditional Value at Risk, or Average Value at Risk. While Value at Risk gives you the loss at a confidence level (the 90%/95%/99% worst return from an investment) it doesn’t tell you what normally happens if you exceed it. Expected Shortfall tells you what the expected loss would be if you exceed a Value at Risk confidence level. It simply averages the returns beyond the confidence level. If you have a 95% confidence level, it averages the lowest 5% of all returns. For 90% confidence level, the lowest 10% of all returns are averaged. These will consist of only losses.

Expected shortfall is highly valuable. We recommend you calculate both percentage loss expected beyond a confidence level and convert the percentages to total dollar amount lost in the actual position or portfolio. We regularly use these for determining if our initial fixed stop loss and trailing overall stop loss are adequate for absorbing painful accidents. If using historically expected shortfall, the further this number is from the mean the more likely extreme negative returns exist.

Expected Shortfall has an alternate variation for positive returns called Expected Tail Return. Instead of averaging the lowest expected returns below a confidence level across the deviation of returns (which are losses) it averages the highest expected returns above a confidence level (which are gains). This allows you to view what is expected to happen on average if you exceed a specific confidence level of returns, and compare it to tail losses. Obviously higher is better, and the further away from the mean return the more likely extreme positive returns could exist. The expected tail return would use the top 1%, top 5%, and top 10% of all returns.

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