CENTRAL LIMIT THEOREM
II UNIT
What is CLT?
According to the central
limit theorem, the mean
of a sample of data will be
closer to the mean of the
overall population in
question, as the sample
size increases,
notwithstanding the actual
distribution of the data.
Assumptions of the Central Limit Theorem
CLT
The central limit theorem says that the sampling distribution of the mean will
always be normally distributed, as long as the sample size is large enough.
Regardless of whether the population has a normal, Poisson, binomial, or any
other distribution, the sampling distribution of the mean will be normal.
Although this concept was first developed by Abraham de Moivre in 1733.
In 1920, when noted Hungarian mathematician George Pólya dubbed it the
central limit theorem
Sample sizes equal to or greater than 30 are often considered sufficient for
the CLT to hold.
A key aspect of CLT is that the average of the sample means and standard
deviations will equal the population mean and standard deviation.
A sufficiently large sample size can predict the characteristics of a
population more accurately.
CLT is useful in finance when analyzing a large collection of securities to
estimate portfolio distributions and traits for returns, risk, and correlation.
Key Components of the Central Limit Theorem
Sampling is successive. This means some sample units are common with
sample units selected on previous occasions.
Sampling is random. All samples must be selected at random so that they
have the same statistical possibility of being selected.
Samples should be independent. The selections or results from one
sample should have no bearing on future samples or other sample results.
Samples should be limited. It's often cited that a sample should be no
more than 10% of a population if sampling is done without replacement.
In general, larger population sizes warrant the use of larger sample sizes.
Sample size is increasing. The central limit theorem is relevant as more
samples are selected.
Why is it used?
This allows for easier statistical analysis and inference. For example, investors
can use central limit theorem to aggregate individual security performance
data and generate distribution of sample means that represent a larger
population distribution for security returns over a period of time.
The central limit theorem is useful
when analyzing large data sets
because it allows one to assume
that the sampling distribution of
the mean will be normally-
distributed in most cases.
Example
The average weight of a water bottle is 30 kg,
with a standard deviation of 1.5 kg. If a sample
of 45 water bottles is selected at random from
a consignment and their weights are
measured, find the probability that the mean
weight of the sample is less than 28 kg.
Solution
Population Sample size: n = 45
Population mean: μ
standard deviation: (which is greater
= 30 kg
σ = 1.5 Kg than 30)
Applications of Central Limit Theorem
The concept of the central limit theorem is used in election polls to estimate the percentage of people
supporting a particular candidate as confidence intervals.
CLT is used in calculating the mean family income in a particular country.
It is used in rolling many identical, unbiased dice.
The probability distribution for the total distance covered in a random walk will approach a normal
distribution.
Flipping many coins will result in a normal distribution for the total number of heads (or, equivalently total
number of tails).
By looking at the sample distribution, CLT can tell whether the sample belongs to a particular population.
It enables us to make conclusions about the sample and population parameters and assists in constructing
good machine-learning models.