Central Limit Theorem (CLT): Definition and Key Characteristics


In probability theory, the central limit theorem (CLT) establishes that the distribution of sample variables approximates a normal distribution as the sample size increases. This article explores the core concepts of the CLT, its significance in finance, and key takeaways.

Understanding the central limit theorem (CLT)

In the realm of probability theory, the central limit theorem (CLT) stands as a fundamental principle. This theorem asserts that as the sample size becomes larger, the distribution of a sample variable converges towards a normal distribution, resembling the familiar “bell curve.” Remarkably, this convergence occurs regardless of the original distribution shape within the population.

To rephrase, the CLT serves as a statistical premise suggesting that when drawing sufficiently large samples from a population characterized by a finite level of variance, the mean of these sampled variables will approximate the mean of the entire population. Moreover, these samples tend to follow a normal distribution, with their variances aligning closely with the population’s variance, a phenomenon governed by the law of large numbers.

Although Abraham de Moivre first explored this idea in 1733, its formalization awaited the efforts of George Pólya, the noted Hungarian mathematician, who bestowed upon it the name “central limit theorem.”

Key components of the central limit theorem

The central limit theorem comprises several pivotal characteristics that center around samples, sample sizes, and the data’s population.

1. Successive sampling: This involves the recurrence of common sample units selected in prior instances.
2. Random sampling: The essence of randomness is integral, ensuring each sample is chosen with equal statistical likelihood.
3. Independence of samples: One sample’s outcomes should remain uninfluenced by the results of other samples or future selections.
4. Limited sampling: For sampling without replacement, a sample’s size should not exceed 10% of the population. Larger populations necessitate larger sample sizes.
5. Increasing sample size: As more samples are drawn, the central limit theorem gains relevance, culminating in a more accurate approximation.

The central limit theorem in finance

The significance of the CLT extends into the realm of finance, particularly when scrutinizing individual stock returns or broader market indices. Its utility lies in simplifying analyses and constructing portfolios with managed risk.

Consider an investor aiming to assess the overall return of a stock index comprising 1,000 equities. Through the central limit theorem, this investor can study a random assortment of stocks to derive estimated returns for the entire index. To ensure reliability, a sampling of 30-50 stocks across various sectors adheres to the theorem’s principles. To curb bias, previously selected stocks must be rotated.

Why is the central limit theorem useful?

The central limit theorem proves invaluable when analyzing extensive datasets. It empowers one to infer that the sampling distribution of the mean aligns with normal distribution in most cases, streamlining statistical analysis and inference. For instance, investors leverage the CLT to aggregate individual security performance data and generate distribution of sample means that represent a broader population distribution of security returns over a specific time span.

Why is the central limit theorem’s minimize sample size 30?

The central limit theorem only holds true when the sample size is considered “sufficiently large.” By convention, a sample size of 30 has been considered as “sufficiently large.” Bigger sample sizes enhance the chances of the sample accurately reflecting the entire population.

By selecting 30 observations, statisticians harness the power of the central limit theorem to ensure more reliable insights. The theorem asserts that with a sufficiently large sample, the distribution of sample means approaches normality, enabling more robust and dependable statistical analysis.

Key takeaways

  • The central limit theorem (CLT) asserts that as sample size increases, the distribution of sample variables approximates a normal distribution.
  • A sample size of around 30-50 is generally sufficient for the CLT to hold.
  • CLT is instrumental in accurately predicting population characteristics, aiding finance professionals in analyzing securities and managing portfolios.
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