Optimize Your Portfolio Using Normal Distribution

16/12/2019 Optimize Your Portfolio Using Normal Distribution
TRADING SKILLS & ESSENTIALS RISK MANAGEMENT
Optimize Your Portfolio Using Normal

Distribution
BY SHOBHIT SETH | Updated Jul 14, 2019
TABLE OF CONTENTS
Normal (Bell Curve) Distribution
Risk and Returns
Modern Portfolio Theory
The Building Blocks
EXPAND +
A Quick Example of MPT
The normal distribution is the probability distribution that plots all of its values in a

symmetrical fashion with most of the results situated around the probability's mean.
https://www.investopedia.com/articles/investing/100714/using-normal-distribution-formula-optimize-your-portfolio.asp 1/13
Normal (Bell Curve) Distribution

Data sets (like the height of 100 humans, marks obtained by 45 pupils in a class, etc.) tend to
have many values at the same data point or within the same range. This distribution of data
points is called the normal or bell curve distribution.
For example, in a group of 100 individuals, 10 may be below 5 feet tall, 65 may stand
between 5 and 5.5 feet and 25 may be above 5.5 feet. This range-bound distribution can be
plotted as follows:
Similarly, data points plotted in graphs for any given data set may resemble different types
of distributions. Three of the most common are left aligned, right aligned and jumbled
distributions:
Note the red trendline in each of these graphs. This roughly indicates the data distribution
trend. The first, “LEFT Aligned Distribution,” indicates that a majority of the data points falls
in the lower range. In the second “RIGHT Aligned Distribution” graph, the majority of data
points fall in the higher end of the range, while the last, “Jumbled Distribution,” represents a
mixed data set without any clear trend.
There are a lot of cases wherein the distribution of data points tends to be around a central
value, and that graph shows a perfect normal distribution – equally balanced on both sides,
with the highest number of data points concentrated in the center.
Here is a perfect, normally distributed data set:
The central value here is 50 (which has the most number of data points), and distribution
tapers off uniformly toward extreme end values of 0 and 100 (which have the fewest number
of data points). The normal distribution is symmetrical around the central value with half the
values on each side.
A lot of real-life examples fit the bell curve distribution:
Toss a fair coin many times (say 100 times or more) and you will get a balanced normal
distribution of heads and tails.
Roll a pair of fair dice many times (say 100 times or more) and the result will be a
balanced, normal distribution centered around the number 7 and uniformly tapering
towards extreme-end values of 2 and 12.
The height of individuals in a group of considerable size and marks obtained by people in
a class both follow normal patterns of distribution.
In finance, changes in the log values of forex rates, price indices, and stock prices are
assumed to be normally distributed.
Risk and Returns

Any investment has two aspects: risk and return. Investors look for the lowest possible risk
for the highest possible return. The normal distribution quantifies these two aspects by the
mean for returns and standard deviation for risk. (For more, see "Mean-Variance Analysis.")
Mean or Expected Value
A particular mean change of a share's price could be 1.5% on a daily basis – meaning that, on
average, it goes up by 1.5%. This mean value or expected value signifying return can be
arrived at by calculating the average on a large enough dataset containing historical daily
price changes of that stock. The higher the mean, the better.
Standard Deviation
Standard deviation indicates the amount by which values deviate on average from the mean.
The higher the standard deviation, the riskier the investment, as it leads to more uncertainty.
Here is a graphical representation of the same:
Hence, the graphical representation of normal distribution through its mean and standard
deviation enables the representation of both returns and risk within a clearly defined range.
It helps to know (and be assured with certainty) that if some data set follows the normal
distribution pattern, its mean will enable us to know what returns to expect, and its standard
deviation will enable us to know that around 68% of the values will be within 1 standard
deviation, 95% within 2 standard deviations and 99% of values will fall within 3 standard
deviations. A dataset which has a mean of 1.5 and standard deviation of 1 is much riskier
than another dataset having a mean of 1.5 and a standard deviation of 0.1.
Knowing these values for each selected asset (i.e. stocks, bonds, and funds) will make an
investor aware of the expected returns and risks.
It’s easy to apply this concept and represent the risk and return on one single stock, bond or
fund. But can this be extended to a portfolio of multiple assets?
Individuals start trading by buying a single stock or bond or investing in a mutual fund.
Gradually, they tend to increase their holdings and buy multiple stocks, funds or other
assets, thereby creating a portfolio. In this incremental scenario, individuals build their
portfolios without a strategy or much forethought. Professional fund managers, traders and
market-makers follow a systematic method to build their portfolio using a mathematical
approach called modern portfolio theory (MPT) that is founded on the concept of “normal
distribution.”
Modern Portfolio Theory

Modern portfolio theory (MPT) offers a systematic mathematical approach which aims to
maximize a portfolio’s expected return for a given amount of portfolio risk by selecting the
proportions of various assets. Alternately, it also offers to minimize risk for a given level of
expected return.
To achieve this objective, the assets to be included in the portfolio should not be selected
solely based on their own individual merit but instead on how each asset will perform
relative to the other assets in the portfolio.
In a nutshell, MPT defines how to best achieve portfolio diversification for the best possible
results: maximum returns for an acceptable level of risk or minimal risk for a desired level of
returns.
The Building Blocks

The MPT was such a revolutionary concept when it was introduced that its inventors won a
Noble Prize. This theory successfully provided a mathematical formula to guide
diversification in investing.
Diversification is a risk management technique, which removes the “all eggs in one basket”
risk by investing in non-correlated stocks, sectors, or asset classes. Ideally, the positive
performance of one asset in the portfolio will cancel the negative performance of other
assets.
To take the average return of the portfolio that has n different assets, the proportion-
weighted combination of the constituent assets' returns is calculated.
Due to the nature of statistical calculations and normal distribution, the overall portfolio
return (Rp) is calculated as:
Rp = ∑ wi Ri
The sum (∑), where wi is the proportionate weight of asset i in the portfolio, Ri is the return
(mean) of asset i.
The portfolio risk (or standard deviation) is a function of the correlations of the included

assets, for all asset pairs (with respect to each other in the pair).
Due to the nature of statistical calculations and normal distribution, the overall portfolio risk
(Std-dev)p is calculated as:
(Std − dev )p =
sqrt [∑ ∑ wi wj (std − dev )i (std − dev )j (cor − cofij )]

i j
Here, cor-cof is the correlation coefficient between returns of assets i and j, and sqrt is the
square-root.
This takes care of the relative performance of each asset with respect to the other.
Although this appears mathematically complex, the simple concept applied here includes
not just the standard deviations of individual assets, but also the related ones with respect
to each other.
A good example is available here from the University of Washington.
A Quick Example of MPT

As a thought experiment, let's imagine we are a portfolio manager who has been given
capital and is tasked with how much capital should be allocated to two available assets (A &
B) so that the expected return is maximized and risk is lowered.
We also have the following values available:
Ra = 0.175
Rb = 0.055
(Std-dev)a = 0.258
(Std-dev)b = 0.115
(Std-dev)ab = -0.004875
(Cor-cof)ab = -0.164
Starting with equal 50-50 allocation to each asset A & B, the Rp calculates to 0.115 and (Std-
dev)p comes to 0.1323. A simple comparison tells us that for this 2 asset portfolio, return as
well as risk is midway between individual values of each asset.
However, our aim is to improve the return of the portfolio beyond the mere average of
either individual asset and reduce the risk, so that it is lower than that of the individual
assets.
Let’s now take a 1.5 capital allocation position in asset A, and a -0.5 capital allocation
position in asset B. (Negative capital allocation means shorting that stock and capital
received is used to buy the surplus of the other asset with positive capital allocation. In other
words, we are shorting stock B for 0.5 times of capital and using that money to buy stock A
for amount 1.5 times of capital.)
Using these values, we get Rp as 0.1604 and (Std-dev)p as 0.4005.
Similarly, we can continue to use different allocation weights to asset A & B, and arrive at
different sets of Rp and (Std-dev)p. According to the desired return (Rp), one can choose the
most acceptable risk level (std-dev)p. Alternately, for the desired risk level, one can select the
best available portfolio return. Either way, through this mathematical model of portfolio
theory, it is possible to meet the objective of creating an efficient portfolio with the desired
risk and return combination.
The use of automated tools allows one to easily and smoothly detect the best possible
allocated proportions easily, without any need for lengthy manual calculations.
The efficient frontier, the Capital Asset Pricing Model (CAPM) and asset pricing using
MPT also evolve from the same normal distribution model and are an extension to MPT.
Challenges to MPT (and Underlying Normal Distribution)

Unfortunately, no mathematical model is perfect and each has inadequacies and limitations.
The basic assumption that stock price returns follow normal distribution itself is questioned
time and again. There is sufficient empirical proof of instances where values fail to adhere to
the assumed normal distribution. Basing complex models on such assumptions may lead to
results with large deviations.
Going further into MPT, the calculations and assumptions about correlation coefficient and
covariance remaining fixed (based on historical data) may not necessarily hold true for future
expected values. For example, the bond and stock markets showed a perfect correlation in
the UK market from 2001 to 2004 period, where returns from both assets went down
simultaneously. In reality, the reverse has been observed over long historical periods prior to
2001.
Investor behavior is not taken into consideration in this mathematical model. Taxes and
transaction costs are neglected, even though fractional capital allocation and the possibility
of shorting assets is assumed.
In reality, none of these assumptions may hold true, which means realized financial
returns may differ significantly from expected profits.
The Bottom Line

Mathematical models provide a good mechanism to quantify some variables with single,
trackable numbers. But due to the limitations of assumptions, models may fail.
The normal distribution, which forms the basis of portfolio theory, may not necessarily apply
to stocks and other financial asset price patterns. Portfolio theory in itself has lots of
assumptions which should be critically examined, before making important financial

decisions.
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FINANCIAL RATIOS
Understanding the Sharpe Ratio
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How Investment Risk Is Quantified
FINANCIAL RATIOS
Learn What a Good Sharpe Ratio Is
FINANCIAL RATIOS
The Coefficient of Variation (COV) as a Measure of
Dispersion and Risk
PORTFOLIO CONSTRUCTION
Example of Applying Modern Portfolio Theory (MPS)
HEDGE FUNDS INVESTING

Understanding Quantitative Analysis Of Hedge Funds
Partner Links
Related Terms
Ringing the Bell Curve
A bell curve is the most common type of distribution for a variable and is therefore considered to be a
normal distribution. The term "bell curve" originates from the fact that the graph used to depict a
normal distribution consists of a bell-shaped line. more
Modern Portfolio Theory (MPT)

Modern portfolio theory (MPT) looks at how risk-averse investors can build portfolios to maximize
expected return based on a given level of market risk. more
Portfolio Variance Definition

Portfolio variance is the measurement of how the actual returns of a group of securities making up a
portfolio fluctuate. more
Standard Deviation Definition

The standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and
is calculated as the square root of the variance. It is calculated as the square root of variance by
determining the variation between each data point relative to the mean. more
Post-Modern Portfolio Theory (PMPT)

Post-modern portfolio theory is a portfolio optimization methodology that uses the downside risk of
returns and builds on modern portfolio theory. more
How to Use the Sharpe Ratio to Analyze Portfolio Risk and Return
The Sharpe ratio is used to help investors understand the return of an investment compared to its risk.
more
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16/12/2019 Optimize Your Portfolio Using Normal Distribution

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

Optimize Your Portfolio Using Normal

BY SHOBHIT SETH | Updated Jul 14, 2019

The normal distribution is the probability distribution that plots all of its values in a

Normal (Bell Curve) Distribution

Here is a perfect, normally distributed data set:

A lot of real-life examples fit the bell curve distribution:

Risk and Returns

Here is a graphical representation of the same:

Modern Portfolio Theory

The Building Blocks

The portfolio risk (or standard deviation) is a function of the correlations of the included

sqrt [∑ ∑ wi wj (std − dev )i (std − dev )j (cor − cofij )]

A good example is available here from the University of Washington.

A Quick Example of MPT

We also have the following values available:

Using these values, we get Rp as 0.1604 and (Std-dev)p as 0.4005.

Challenges to MPT (and Underlying Normal Distribution)

The Bottom Line

assumptions which should be critically examined, before making important financial

HEDGE FUNDS INVESTING

Modern Portfolio Theory (MPT)

Portfolio Variance Definition

Standard Deviation Definition

Post-Modern Portfolio Theory (PMPT)

Terms of Use Contact Us News

Investopedia is part of the Dotdash publishing family.

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