Scribd
Upload
24 views4 pages

Study Notes

Uploaded by

Augustine Iisa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
24 views4 pages

Study Notes

Uploaded by

Augustine Iisa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
You are on page 1/ 4

STUDY NOTES

EFA and CFA

Factor analysis attempts to determine which sets of observed variables share common variance–
covariance characteristics (Variance
and covariance are two terms used often in
statistics. Although they sound similar, they’re quite different. Variance
measures how spread out values are in a given dataset. Covariance
measures how changes in one variable are associated with changes in a
second variable) that define theoretical constructs or factors (latent variables). Factor analysis
presumes that some factors that are smaller in number than the number of observed variables are
responsible for the shared variance–covariance among the observed variables. In practice, one
collects data on observed variables and uses factor-analytic techniques to either confirm that a
particular subset of observed variables define each construct or factor, or explore which observed
variables relate to factors. In exploratory factor model approaches, we seek to find a model that fits
the data, so we specify different alternative models, hoping to ultimately find a model that fits the
data and has theoretical support. This is the primary rationale for exploratory factor analysis (EFA). In
confirmatory factor model approaches, we seek to statistically test the significance of a hypothesized
factor model—that is, whether the sample data confirm that model. Additional samples of data that
fit the model further confirm the validity of the hypothesized model. This is the primary rationale for
confirmatory factor analysis (CFA).

What Is Variance?
The term variance refers to a statistical measurement of the spread
between numbers in a data set. More specifically, variance measures how
far each number in the set is from the mean (average), and thus from
every other number in the set. Variance is often depicted by this symbol:
σ2. It is used by both analysts and traders to determine volatility and
market security.

The square root of the variance is the standard deviation (SD or σ), which
helps determine the consistency of an investment’s returns over a period
of time.

KEY TAKEAWAYS
 Variance is a measurement of the spread between numbers in a
data set.
 In particular, it measures the degree of dispersion of data around the
sample's mean.
 Investors use variance to see how much risk an investment carries
and whether it will be profitable.
 Variance is also used in finance to compare the relative performance
of each asset in a portfolio to achieve the best asset allocation.
 The square root of the variance is the standard deviation.

Investopedia / Alex Dos Diaz

Understanding Variance
In statistics, variance measures variability from the average or mean. It is
calculated by taking the differences between each number in the data set
and the mean, then squaring the differences to make them positive, and
finally dividing the sum of the squares by the number of values in the data
set. Software like Excel can make this calculation easier .

Variance is calculated by using the following formula:

�2=∑�=1�(��−�‾)2�where:��=Each value in the data set


�‾=Mean of all values in the data set�=Number of values in the d
ata setσ2=N∑i=1n(xi−x)2where:xi=Each value in the data setx=Mean
of all values in the data setN=Number of values in the data set
You can also use the formula above to calculate the variance in areas
other than investments and trading, with some slight alterations. For
instance, when calculating a sample variance to estimate
a population variance, the denominator of the variance equation becomes
N − 1 so that the estimation is unbiased and does not underestimate the
population variance.

Advantages and Disadvantages of Variance


Statisticians use variance to see how individual numbers relate to each
other within a data set, rather than using broader mathematical techniques
such as arranging numbers into quartiles. The advantage of variance is
that it treats all deviations from the mean as the same regardless of their
direction. The squared deviations cannot sum to zero and give the
appearance of no variability at all in the data.

One drawback to variance, though, is that it gives added weight to outliers.


These are the numbers far from the mean. Squaring these numbers
can skew the data. Another pitfall of using variance is that it is not easily
interpreted. Users often employ it primarily to take the square root of its
value, which indicates the standard deviation of the data. As noted above,
investors can use standard deviation to assess how consistent returns are
over time.

In some cases, risk or volatility may be expressed as a standard deviation


rather than a variance because the former is often more easily interpreted.

Example of Variance in Finance


Here’s a hypothetical example to demonstrate how variance works. Let’s
say returns for stock in Company ABC are 10% in Year 1, 20% in Year 2,
and −15% in Year 3. The average of these three returns is 5%. The
differences between each return and the average are 5%, 15%, and −20%
for each consecutive year.

Squaring these deviations yields 0.25%, 2.25%, and 4.00%, respectively. If


we add these squared deviations, we get a total of 6.5%. When you divide
the sum of 6.5% by one less the number of returns in the data set, as this
is a sample (2 = 3-1), it gives us a variance of 3.25% (0.0325). Taking the
square root of the variance yields a standard deviation of 18% (√0.0325 =
0.180) for the returns.

Frequently Asked Questions


How Do I Calculate Variance?
Follow these steps to compute variance:

1. Calculate the mean of the data.


2. Find each data point's difference from the mean value.
3. Square each of these values.
4. Add up all of the squared values.
5. Divide this sum of squares by n – 1 (for a sample) or N (for the
population).

What Is Variance Used for?


Variance is essentially the degree of spread in a data set about the mean
value of that data. It shows the amount of variation that exists among the
data points. Visually, the larger the variance, the "fatter" a probability
distribution will be. In finance, if something like an investment has a
greater variance, it may be interpreted as more risky or volatile.
Why Is Standard Deviation Often Used More Than
Variance?
Standard deviation is the square root of variance. It is sometimes more
useful since taking the square root removes the units from the analysis.
This allows for direct comparisons between different things that may have
different units or different magnitudes. For instance, to say that increasing
X by one unit increases Y by two standard deviations allows you to
understand the relationship between X and Y regardless of what units they
are expressed in.

You might also like