Central Limit Theorem (CLT) is an important result in statistics, most specifically, probability theory. This theorem enables you to measure how much the means of various samples vary without having to use other sample means as a comparison. The Central Limit Theorem is popularly used in case of financial analysis while evaluating the risk of financial holdings against the possible rewards.
In general, the CLT works if statistics calculated based on certain data provides more information than the process would if just one instance was studied. For example, taking samples from a large group of people in a population is a more accurate way to determine averages than from one individual.
The CLT reveals exactly what the shape of the mean distribution will be when repeated samples are drawn from a given population. More specifically, as sample sizes become larger, the mean distribution that is measured from repeated sampling will reach the normal limits.
So, you can use your data to answer questions about specific populations like:
- What is the mean employee income for the entire enterprise?
- These insights indicate that 65% of all promotional codes in our businesses codes go unused. Is this true?
CLT is significant because the results hold regardless of what shape the original population distribution was, which makes it important for statistical inference. The more data that's gathered, the more accurate the statistical inferences become, meaning more certainty in estimates.
Central Limit Theorem and Inferential Statistics
Inferential statistics uses sample data to make reasonable judgments about the population where data originated. It’s used to examine relationships between variables within a sample and make predictions about how the variables will relate to a larger population.
Inferential statistics are particularly useful because it’s difficult (and in some cases, impossible), expensive, and time-consuming to study an entire population of people. But by utilizing a statistically valid sample and inferential statistics, a data scientist can perform research that produces accurate results.
Some techniques that are used in inferential statistics include:
- Logistic regression analyses
- Correlation analyses
- Linear regression analyses
- Structural equation modeling
Business Utilization of Central Limit Theorem and Statistical Inferences
Usually, businesses measure financial holdings regarding the end benefit. However, as there is risk associated with these financial holdings, central limit theorem helps in giving a clear picture of the risk involved versus the benefits. This inference is drawn based on the pattern from the normal distribution and utilizing the central limit theorem. Businesses analyze such situations by collating the trend reports regarding how individual contributors to the business have performed during the past business cycles and put that information into an investment model. As the returns from the contributors vary, the associated mean value for each is calculated based on taking several sets of samples reflecting the performance of each contributor.
With this, two key statistical inference can be drawn – one is the approximate average return from each contributor and the normal distribution of the sample averages. This information provides the information regarding how much risk is associated with each contributor to take appropriate decisions.
The CLT provides results that indicate that for a large enough sample size, the distribution of x becomes closer to normal regardless of what the underlined distribution of X is. Basically, this means that no matter the circumstance, it's possible to make probabilistic inferences about population parameter values based on statistic samples.
Example of a Retail Company
A retail company has a contract for their employees working in product manufacturing and distribution which says that they receive bonus pay if they can produce at least 100 products per day that are free of defects.
- Random variable = individual worker quality
- Standard deviation is σ = 10
To evaluate the quality, the company uses a CLT:
- Samples from 50 random employees will be taken, and quality will be examined for one day.
- They will calculate the average of x (defect free values)
- If the average is greater than 104, all the employees will get a bonus.
The CLT can also be used for weighted sums, such as in finance. For example, it can be used to determine the return for a stock portfolio:
- Pi of portfolio invested in stock
- The total return on the portfolio: given that is the return of the ith stock.
- Expected portfolio return:
- Expected portfolio return:
The CLT means that if the portfolio contains enough stocks, the return will be normally distributed, meaning E (R) and variance V (R).
Leveraging Results from Statistical Data
The plethora of business uses for Central Limit Theorem across industries, including healthcare, finance, manufacturing, education and academia, and science. It necessitates a strict, unbiased approach to modern statistics to perform consistent calculations and make the appropriate correlations between sample data. Ensuring accuracy in results, and concise communication of outcomes requires the expertise of experienced statistical analysts.
Research Optimus (ROP) is a research and analytics firm with a global clientele and a commitment to providing informative and customized insights intended to help businesses maximize their decision-making capabilities. With authoritative and multidimensional documentation, companies will be able to understand their statistical data and leverage the results. Contact us to know how Research Optimus will be able to assist you with your financial analysis and other market research related requirements.