Explaining Diversification with Gain and Loss

This paper shows how to explain diversification using gain and loss. The gain-loss approach focuses on the cancellation of returns that occurs as stocks enter a portfolio. Simple algebra and arithmetic explain exactly how diversification acts to raise a portfolio's gain-loss ratio. The method requires no knowledge or use of variance or covariance. In addition, the paper shows how gain and loss are consistent with the capital asset pricing model (CAPM) and interprets the gain-loss reward-risk concepts of co-gain and co-loss in a CAPM context.teaching, CAPM