Portfolio Analysis Based on the Shortfall Concept

Abstract

Investors often claim that risk is not equal to volatility. While the variance or standard deviation is an appropriate measure of volatility, the shortfall approach is a superior alternative in measuring risk. Shortfall measures define risk as earning less than a desired minimum return. Therefore only that part of the return distribution left of the minimum return is considered in calculating risk. Shortfall measures can be used to measure portfolio risk and risk adjusted performance in a very general and flexible way. This article gives a survey of the major characteristics of shortfall measures and their use in asset allocation. The second part of our article describes an investment product based on a dynamic benchmark adjustment process. The adjustment procedure is governed by the probability of falling below the investors’ desired minimum return.