The Gain‐Loss Spread: A New and Intuitive Measure of Risk |
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| Authors: | Javier Estrada |
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| Institution: | 1. Professor of Finance at IESE Business School in Barcelona, Spain. He is also the author of Finance in a Nutshell. A No Nonsense Companion to the Tools and Techniques of Finance, FT Prentice Hall (2005).;2. I would like to thank Manolo Campa, Jennifer Conrad, Roger Koenker, and Rawley Thomas for their comments. Gabriela Giannattasio provided valuable research assistance. The views expressed below and any errors that may remain are entirely my own. |
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| Abstract: | The standard deviation, arguably the most widely‐used measure of risk, suffers from at least two limitations. First, the measure has little intuitive appeal (defined as it is by the square root of the average quadratic deviation from the arithmetic mean return). Second, investors tend to associate risk more with bad outcomes than with volatility per se. To overcome these limitations, this article introduces a new measure of risk, the gain‐loss spread (GLS), which takes into account the probability of a loss, the average size of the loss, and the average gain—all variables that investors consider relevant when assessing risk. The author presents evidence that the GLS is both highly correlated with the standard deviation—thus providing basically the same information about risk—and more correlated with mean returns than both the standard deviation and beta, thereby offering a tighter link between risk and return. |
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