Skip to content
GetProfitable
Search
Dictionary

Central limit theorem

Averages of many independent observations tend toward a normal distribution even when the observations themselves are not normal. The reason standard errors work at all.

The CLT is why you can put a confidence interval on a mean return without knowing the shape of individual trade outcomes. Sum enough independent draws and the sum's distribution smooths out.

Markets break two of its conditions. Returns are not independent, because volatility clusters, and their tails can be heavy enough that the variance is poorly estimated. Convergence then takes far longer than the textbook suggests, and the normal approximation understates how often extreme averages occur.

Practical reading: trust the CLT for the mean of a few hundred well-behaved trade results, distrust it for anything involving the tail, such as max-drawdown or the worst month. For those, simulate rather than assume.

Related: standard-error, fat-tails, law-of-large-numbers, monte-carlo-simulation

Educational only, not advice. Spotted an error? Post in Site Feedback.