RiskMetrics - Introducing Loss-in-Extreme-Markets (XLoss)
Introducing Loss-in-Extreme-Markets (XLoss)
Apply XLoss to measure your loss potential in adverse markets
Extreme market risk
To address the question of how much money you could lose due to adverse market movements, RiskMetrics introduced a statistic called Loss-in-Extreme-Markets (XLoss). XLoss measures your expected loss in extreme market conditions, where returns exceed the forecasted 95th percentile worst-case loss level.
Click on the Flash animation below to learn how we determined XLoss for Coke stock (or view the non-Flash version):
Just like RiskGrades, we calculate XLoss for all your holdings and your combined portfolio. You can use the XLoss statistic to estimate how much you might lose over a specified time horizon, such as one day or one month. For our portfolio below, Yahoo! has the highest daily XLoss ($1,003), followed by WWWFX ($674). Across the entire portfolio, we can expect to lose $2,198 on a bad day (i.e., 5% of the time, or 1 in 20 trading days). You can use XLoss to test your risk tolerance: would it churn your stomach to swallow losses of that magnitude in a single day? If so, you may want to reduce your positions.
Due to diversification, XLoss will always be less than the sum of individual-asset XLosses. It is unlikely that all your worst-case losses would occur on the same day. XLoss diversification benefit is just the sum of the individual-asset XLosses minus the portfolio XLoss (e.g., $3,131 - $2,198 = $933 in the above portfolio).
Limitations of XLoss
XLoss is a good indicator of losses you might experience in adverse markets. Beware, however, that you may experience even larger losses on occasion. Remember that XLoss is your expected 95% confidence worst case loss, not your 100% worst case loss. Also keep in mind that the XLoss statistic is based on observed historical losses, which may not be indicative of future losses if there are radical shifts in the company's business or the overall market.