Reading 8: Statistical Concepts

and Market Returns

 Learning Outcome Statements
• Covered
• 8e, 8f, 8g, 8i, 8j, 8k, 8l, 8m

• Not Covered
• 8a, 8b, 8c, 8d, 8h
 Mean – I
The formulae for the population mean and a sample mean are
essentially the same; both are arithmetic means:

Population Mean:
N

X i
 i 1
N
Sample Mean:
n

X i
X i 1
n
 Mean – II
Three other types of mean are the weighted average (weighted
mean), geometric mean, and harmonic mean:

Weighted Average (Weighted Mean):

n
XW   w i X i
i 1
Geometric Mean:
1/ n
 n

X1 X 2  X n   X1 X 2  X n     Xi 
1/ n
G n

 i 1 
Harmonic Mean:
n
XH  n
1

i 1 X i
 Mean – III
The geometric mean is used to calculate average (compound)
returns:
1  rG  n
 1  r1   1  r2    1  rn 
1/ n
 n

rG     1  rt   1
 t 1 
The harmonic mean can be used to compute the average price
per share paid when the same value of shares is purchased at
several different per-share prices.

Note that:
X H  XG  X
 Mean – IV
Example: A portfolio has annual returns of +5%, +2%,
–4%, and +10%. What is the average (compound) annual
return?
rG  n  1  r1   1  r2    1  rn   1

 4
 1.05   1.02   0.96   1.10  1

 4
 1.05   1.02   0.96   1.10 
Example: You make three £10,000 purchases of XYZ stock:
one at £25/share, one at £30/share, and one at £35/share.
What average per-share price did you pay?
3
XH   £29.44
1 1 1
£25 £30 £35
 Practice Question
Annual returns on a portfolio for the last six years have been
12%, 5%, –2%, 10%, –1%, and 1%. The arithmetic and
geometric mean returns, respectively, are closest to:
 
Arithmetic Geometric
A. 4.167% 3.260%
B. 4.167% 4.031%
C. 5.167% 4.031%
 Practice Question
Annual returns on a portfolio for the last six years have been
12%, 5%, –2%, 10%, –1%, and 1%. The arithmetic and
geometric mean returns, respectively, are closest to:
 
Arithmetic Geometric
A. 4.167% 3.260%
B. 4.167% 4.031%
C. 5.167% 4.031%

Correct answer: B. 4.167% 4.031%

Arithmetic mean =
(12% + 5% + –2% + 10% + –1% + 1%)/6 = 4.167%
Geometric mean =
[(1.12)(1.05)(1.02)(1.10)(1.01)(1.01)]1/6 – 1 = 4.031%
 Median and Mode
The median is the middle value in a set of data: half the values
are greater than the median, half are less:
• With an odd number of observations, the median is the middle
one:
–9%, –9%, –2%, 1%, 1%, 3%, 6%
median = 1%
• With an even number of observations, the median is the
arithmetic average of the middle two:
–9%, –6%, –5%, –4%, –2%, 6%, 7%, 9%
median = (–4% + –2%)/2 = –3%
The mode is the value that occurs most often:
–9%, –7%, –4%, –2%, –1%, –1%, 0%, 6%
mode = –1%
Data sets can have more than one mode (bimodal, etc.).
 Quantiles (Fractiles)
Percentiles are relatively common: the 89th percentile, for
example, means that 89% of the values in a data set are less
than the given value.
Analogously,
• 6/10 of the values are less than the 6th decile.
• 2/5 of the values are less than the 2nd quintile.
• 3/4 of the values are less than the 3rd quartile.
For a data set with n values, the location of the yth percentile is
calculated as:
y
Ly   n  1
100
For example, with 57 values, the 28th percentile is located at
position 58 × 0.28 = 16.24; this can be interpreted as 24% of the
way between the 16th and 17th values.
 Practice Question
Given 12 annual returns of –3%, –2%, 1%, 1%, 4%, 6%, 8%,
8%, 9%, 9%, 11%, and 15%, the median return and the value of
the 35th percentile are, respectively, closest to:
 
Median 35th Percentile
A. 7% 1.60%
B. 7% 2.65%
C. 9% 2.65%
 Practice Question
Given 12 annual returns of –3%, –2%, 1%, 1%, 4%, 6%, 8%,
8%, 9%, 9%, 11%, and 15%, the median return and the value of
the 35th percentile are, respectively, closest to:
 
Median 35th Percentile
A. 7% 1.60%
B. 7% 2.65%
C. 9% 2.65%

Correct answer: B. 7% 2.65%

Median = (6% + 8%)/2 = 7%

35th Percentile location = (12 + 1) × 0.35 = 4.55

35th Percentile value = 1% + 0.55(4% – 1%) = 2.65%
 Measures of Dispersion – I
Annual returns: –9%, –7%, –6%, –5%, –2%, 5%, 7%, 9%
Note: Mean return = –1%.

Range: The difference between the highest value and the lowest
value: 9% – (–9%) = 18%.

Summing the differences of the observations and the mean

always gives zero: [–9% – (–1%)] + . . . + [9% – (–1%)] = 0.

The problem: Some differences are positive, some negative; the

positives and negatives always cancel out.

Solution: Eliminate the negative signs.

 Measures of Dispersion – II
Annual returns: –9%, –7%, –6%, –5%, –2%, 5%, 7%, 9%
Note: Mean return = –1%.

Mean Absolute Deviation (MAD): Use absolute values to

eliminate the negative signs:
n

X i X
MAD  i 1
n
MAD =
[|–9% – (–1%)| + |–7% – (–1%)| + . . . + |9% – (–1%)|]/8
= 6.125%

The absolute value function isn’t compatible with calculus,

so . . .
 Measures of Dispersion – III
Annual returns: –9%, –7%, –6%, –5%, –2%, 5%, 7%, 9%
Note: Mean return = –1%.

Variance: Use squared values to eliminate the negative signs:

Variance of a Population: N

 X  
2
i
2  i 1
N
n
Variance of a Sample:
 X 
2
i X
s2  i 1
n 1
 Measures of Dispersion – IV
Annual returns: –9%, –7%, –6%, –5%, –2%, 5%, 7%, 9%
Note: Mean return = –1%.

Example: If the annual returns given are the entire population:

( 9%  ( 1%)) 2
 ( 7%  ( 1%))2
   (9%  ( 1%))2
2 
8
 0.004275
If the annual returns given are a sample:

( 9%  ( 1%))2  ( 7%  ( 1%))2    (9%  ( 1%))2

s 
2

7
 0.004886
 Measures of Dispersion – V
Annual returns: 9%, –7%, –6%, –5%, –2%, 5%, 7%, 9%
Note: Mean return = –1%.

The units of variance are the square of the units of the underlying
measurements. To overcome that incompatibility, we have:

Standard Deviation: the square root of variance

Standard deviation of a population:

  2
Standard deviation of a sample:
s  s2
Standard deviation has the same units as the original data.
 Measures of Dispersion – VI
Annual returns: –9%, –7%, –6%, –5%, –2%, 5%, 7%, 9%
Note: Mean return = –1%.

Example: If the annual returns given are the entire population:

   2  0.004275  6.54%

If the annual returns given are a sample:

s  s 2  0.004886  6.99%
 Practice Question
Given a sample of 4 annual returns of –3%, 1%, 4%, and 6%, the MAD and
standard deviation are, respectively, closest to:
 
MAD Standard Deviation
A. 3.00% 3.39%
B. 3.00% 3.92%
C. 4.00% 3.92%
 Practice Question
Given a sample of 4 annual returns of –3%, 1%, 4%, and 6%, the MAD and
standard deviation are, respectively, closest to:
 
MAD Standard Deviation
A. 3.00% 3.39%
B. 3.00% 3.92%
C. 4.00% 3.92%

Correct answer: B. 3.00% 3.92%

Mean = (–3% + 1% + 4% + 6%)/4 = 2%

MAD = (|–3% – 2%| + |1% – 2%| + |4% – 2%| + |6% – 2%|)/4 = 3%

 3%  2%   1%  2%    4%  2%    6%  2% 
2 2 2 2

s
3
 3.92%
Coefficient of Variation, Sharpe Ratio – I
The coefficient of variation (CV) and the Sharpe ratio are closely
related; both are based on the mean return of a security or
portfolio and its standard deviation of returns:
s
Coefficient of Variation 
X
s  security's standard deviation of returns
X  security's mean return
Rp  RF
Sharpe Ratio 
sp
R p  portfolio's mean return
RF  mean risk-free return
s p  portfolio's standard deviation of returns
Coefficient of Variation, Sharpe Ratio – II
CV is a measure of risk per unit of return; a lower CV is better
than a higher CV. The Sharpe ratio is a measure of return per unit
of risk; a higher Sharpe ratio is better than a lower Sharpe ratio.

Example: Suppose that the risk-free rate is 2%.

Investment A Investment B
Mean return 10% 8%
Std. dev. of returns 8% 4%
Coefficient of variation 0.8 0.5
Sharpe ratio 1.0 1.5
Based on these measures, Investment B is superior.
 Skewness – I
Normal distributions (and other symmetric distributions) have
zero skewness.

Positive skewness
indicates asymmetry with
more (or more extreme)
outliers in the right tail:

Negative skewness
indicates asymmetry with
more (or more extreme)
outliers in the left tail:

Absolute skewness > 0.5 is significant.

 Skewness – II
For a positively skewed distribution with a single mode:

mean > median > mode

For a negatively skewed distribution with a single mode:

mean < median < mode

 Kurtosis – I
Kurtosis measures whether the peak of the distribution is higher
than that of a normal distribution (kurtosis > 3) or less than that
of a normal distribution (kurtosis < 3).

A distribution’s
kurtosis minus 3.0 is
called its excess
kurtosis. Absolute
excess kurtosis > 1.0
is significant; i.e.,
kurtosis > 4.0 or
kurtosis < 2.0.
 Kurtosis – II
A distribution with positive excess kurtosis (kurtosis > 3) is
called leptokurtic; it also tends to have fatter tails than a normal
distribution.

A distribution with negative excess kurtosis (kurtosis < 3) is

called platykurtic; it also tends to have thinner tails than a
normal distribution.

A distribution with zero excess kurtosis (kurtosis = 3) is called

mesokurtic.
 Practice Question
Investments X, Y, and Z all have the following characteristics:
X Y Z
Expected return 8% 8% 8%
Std. dev. of returns 6% 6% 6%
Skewness 1.0 0.0 0.1
Excess kurtosis –0.5 0.0 0.8

For an investor who is most concerned about not losing his principal, the best
investment and the worst investment are likely to be, respectively:

BestWorst
A. X Z
B. Y X
C. X Y
 Practice Question
Investments X, Y, and Z all have the following characteristics:
X Y Z
Expected return 8% 8% 8%
Std. dev. of returns 6% 6% 6%
Skewness 1.0 0.0 0.1
Excess kurtosis –0.5 0.0 0.8

For an investor who is most concerned about not losing his principal, the best
investment and the worst investment are likely to be, respectively:
Correct answer: A. X Z
BestWorst
A. X Z X has positive skewness and negative
B. Y X excess kurtosis, both of which lead to less
C. X Y probability of negative returns. Z has
essentially zero skewness, but its positive
excess kurtosis leads to a higher
probability of extreme negative returns.