Statistical Concepts

and Market Return

Reading 7

IFT Notes for the 2015 Level 1 CFA® exam

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Contents

Introduction ..................................................................................................................................... 2
Some Fundamental Concepts .......................................................................................................... 2
Summarizing Data Using Frequency Distributions ........................................................................ 4
The Presentation of Data Graphic ................................................................................................... 6
Measures of Central Tendency ....................................................................................................... 8
Other Measures of Location: Quantiles ........................................................................................ 12
Measures of Dispersion................................................................................................................. 14
Symmetry and Skewness in Return Distributions ........................................................................ 20
Kurtosis in Return Distributions ................................................................................................... 21
10. Using Geometric and Arithmetic Means ............................................................................... 22
Summary ....................................................................................................................................... 23
Next Steps ..................................................................................................................................... 26

This document should be read in conjunction with the corresponding reading in the 2015 Level I
CFA® Program curriculum.

Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or
quality of the products or services offered by Irfanullah Financial Training. CFA Institute,
CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute.

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1. Introduction

Statistical methods provide a powerful set of tools for analyzing data and drawing conclusions
from them. These are particularly useful when we are analyzing asset returns, earning growth
rates, commodity prices, or any other financial data. Descriptive statistics is the branch of
statistics that deals with describing and analyzing data. In this reading, we will study statistical
methods that allow us to summarize return distributions.
Specifically, we will explore four properties of return distributions:
 Where the returns are centered (central tendency)
 How far returns are dispersed from their center (dispersion)
 Whether the distribution of returns is symmetrically shaped or lopsided (skewness)
 Whether extreme outcomes are likely (kurtosis)

2. Some Fundamental Concepts

2.1 The Nature of Statistics

The term statistics can have two broad meanings, one referring to data and the other to method.
Statistical methods include:
 Descriptive statistics: Study of how data can be summarized effectively to describe the
important aspects of large data sets.
 Statistical inference: Making forecasts, estimates, or judgments about a larger group from
the smaller group actually observed.

2.2 Populations and Samples

A population is defined as all members of a specified group. Any descriptive measure of a

population characteristic is called a parameter.
A sample is a subset of a population. Any descriptive measure of a sample characteristic is called
a sample statistic (statistic, for short).

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2.3 Measurement Scales

To choose the appropriate statistical method for summarizing and analyzing data, we need to
distinguish among different measurement scales. All data measurements are taken on one of the
following scales:

 Nominal scales: These scales categorize data but do not rank them. Hence, they are often
considered the weakest level of measurement. An example could be if we assigned
integers to mutual funds that follow different investment strategies. Number 1 might refer
to a small-cap value fund, number 2 might refer to a large-cap value fund, and so on for
each possible style.
 Ordinal scales: These scales sort data into categories that are ordered with respect to
some characteristic. An example is Standard & Poor’s star ratings for mutual funds. One
star represents the group of mutual funds with the worst performance. Similarly, groups
with two, three, four and five stars represent groups with increasingly better performance.
 Interval scales: These scales not only rank data, but also ensure that the differences
between scale values are equal. The Celsius and Fahrenheit scales are examples of such
scales. The difference in temperature between 10oC and 11oC is the same amount as the
difference between 40oC and 41oC. The zero point of an interval scale does not reflect
complete absence of what is being measured. Hence, it is not a true zero point or natural
zero.
 Ratio scales: These scales have all the characteristics of interval scales as well as a true
zero point as the origin. This is the strongest level of measurement. The rate of return on
an investment is measured on a ratio scale. A return of 0% means the absence of any
return.

Worked Example 1: Identifying Scales of Measurement

Note: This example has been reproduced from the curriculum.
State the scale of measurement for each of the following:
1. Credit ratings for bond issues.
2. Cash dividends per share.
3. Hedge fund classification types.
4. Bond maturity in years.

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Solution to 1:

Credit ratings are measured on an ordinal scale. A rating places a bond issue in a category, and
the categories are ordered with respect to the expected probability of default. But the difference
in the expected probability of default between AA− and A+, for example, is not necessarily equal
to that between BB− and B+. In other words, letter credit ratings are not measured on an interval
scale.

Solution to 2:

Cash dividends per share are measured on a ratio scale. For this variable, 0 represents the
complete absence of dividends; it is a true zero point.

Solution to 3:

Hedge fund classification types are measured on a nominal scale. Each type groups together
hedge funds with similar investment strategies. In contrast to credit ratings for bonds, however,
hedge fund classification schemes do not involve a ranking. Thus such classification schemes are
not measured on an ordinal scale.

Solution to 4:

Bond maturity is measured on a ratio scale.

3. Summarizing Data Using Frequency Distributions

A frequency distribution is a tabular display of data summarized into a relatively small number
of intervals. In order to construct a frequency distribution, we can follow the following
procedure:

 Sort the data in ascending order.

 Calculate the range of the data, defined as Range = Maximum value – Minimum value.
 Decide on the number of intervals in the frequency distribution, k.

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 Determine interval width as Range/k.

 Determine the intervals by successively adding the interval width to the minimum value
to determine the ending points of intervals. Stop after reaching an interval that includes
the maximum value.
 Count the number of observations falling in each interval.
 Construct a table of the intervals listed from smallest to largest that shows the number of
observations falling in each interval.

The following example illustrates the process.

Worked Example 2: Construction of a Frequency Table

Say you are evaluating 100 stocks with prices ranging from 46 to 65.

Stock Price (Absolute) Cumulative Relative Cumulative Relative

Frequency Frequency Frequency Frequency
46-50 25 25 0.25 0.25
51-55 35 60 0.35 0.60
56-60 29 89 0.29 0.89
61-65 11 100 0.11 1.00

In order to summarize this data, we have divided the stock prices into 4 intervals of stock price
each having a width of 5. The actual number of observations in a given interval is called the
absolute frequency, or simply the frequency. For example, there are 25 stocks falling in the
interval of price range from 46-50. The relative frequency is the absolute frequency of each
interval divided by the total number of observations. The cumulative relative frequency
cumulates the relative frequencies as we move from the first to the last interval. It tells us the
fraction of observations that are less than the upper limit of each interval. So there are 60
observations less than the stock price of 55. The frequency distribution gives us a sense of where
most of the observations lie and also whether the distribution is evenly distributed, lopsided, or
peaked.

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4. The Presentation of Data Graphic

A graphical display allows us to visualize important characteristics of a data set. In this section
we discuss the histogram, frequency polygon, and the cumulative frequency distribution.

4.1 The Histogram

A histogram is a bar chart of data that have been grouped into a frequency distribution. The
advantage of the visual display is that we can quickly see where most of the observations lie.
Consider the histogram shown below.

Histogram
40
35
30
25
Frequency

20
15 Frequency
10
5
0
46-50 51-55 56-60 61-65
Stock Price

The height of each bar in the histogram represents the absolute frequency for each interval.

4.2 The Frequency Polygon and the Cumulative Frequency Distribution

The frequency polygon is constructed when we plot the midpoint of each interval on the x-axis
and the absolute frequency for that interval on the y-axis. We then connect the neighboring
points with a straight line. The figure below is an example of a frequency polygon.

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Frequency Polygon
40

35

30

25

20
Frequency
15

10

0
46-50 51-55 56-60 61-65

Another graphical tool is the cumulative frequency distribution. Such a graph can plot either the
cumulative absolute or cumulative relative frequency against the upper interval limit. The
cumulative frequency distribution allows us to see how many or what percent of the observations
lie below a certain value. The figure below is an example of a cumulative frequency distribution.

Cumulative Frequency
120

100

80

60
Cumulative Frequency

40

20

0
46-50 51-55 56-60 61-65

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5. Measures of Central Tendency

A measure of central tendency specifies where the data are centered. Measures of location
include not only measures of central tendency but other measures that illustrate the location or
distribution of data. As a basis for understanding the measures of central tendency, let us
consider the stock returns of a company over the last 10 years: 2%, 5%, 4%, 7%, 8%, 8%, 12%,
10%, 8%, and 5%. We will use this data set to explain various measures of central tendency.

5.1 The Arithmetic Mean

The arithmetic mean is the sum of the observations divided by the number of observations. It is
the most frequently used measure of the middle or center of data.

The Population Mean

The population mean is the arithmetic mean computed for a population. A given population has
only one mean. For a finite population, the population mean is:
∑𝑁𝑖=1 𝑋𝑖
µ=
𝑁

where N is the number of observations in the entire population and Xi is the ith observation.

For the dataset described above,

2 + 5 + 4 + 7 + 8 + 8 + 12 + 10 + 8 + 5
µ=
10

µ = 6.9%

The Sample Mean

The sample mean is calculated like the population mean, except we use the sample values.
∑𝑛𝑖=1 𝑋𝑖
𝑋̅ =
𝑛

where n is the number of observations in the sample. If the sample data is: 8, 12, 10, 8 and 5, the
sample mean can be calculated as:

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8 + 12 + 10 + 8 + 5
𝑋̅ =
5
𝑋̅ = 8.6

Properties of the Arithmetic Mean

As analysts, we often use the mean return as a measure of the typical outcome for an asset. Some
of the advantages of the arithmetic mean are:
 Uses all information about the size and magnitude of the observations
 Easy to work with and compute mathematically
One of the drawbacks of the arithmetic mean is its sensitivity to extreme values. Because all
observations are used to compute the mean, the arithmetic mean can be pulled sharply upward or
downward by extremely large or small observations, respectively. Unusually large or small
observations are called outliers.

5.2 The Median

The median is the value of the middle item of a set of items that has been sorted into ascending
or descending order. In an odd numbered sample of n items, the median occupies the (n + 1)/2
position. In an even numbered sample, we define the median as the mean of the values of items
occupying the n/2 and (n + 2)/2 positions (the two middle items).

Sorting the sample data given above we have: 5%, 8%, 8% 10%, 12%. Here n = 5. The position
or location of the median number is given by (n + 1)/2 = 3 and the median value is 8%.

A distribution has only one median. An advantage of the median is that, unlike the mean,
extreme values do not affect it. The median, however, does not use all the information about the
size and magnitude of the observations. It focuses only on the relative position of the ranked
observations. Another disadvantage is that it is more tedious to compute as compared to the
mean.

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5.3 The Mode

The mode is the most frequently occurring value in a distribution. For the following data set: 5%,
8%, 8% 10%, 12%, the mode is 8%. A distribution can have more than one mode, or even no
mode. When a distribution has one most frequently occurring value, the distribution is said to be
unimodal. If a distribution has two modes, it is bimodal. The mode is the only measure of central
tendency that can be used with nominal data. Stock return data and other data from continuous
distributions may not have a modal outcome. When such data are grouped into intervals,
however, we often find an interval (possibly more than one) with the highest frequency. This is
called the modal interval (or intervals).

5.4 Other Concepts of Mean

The arithmetic mean is a fundamental concept for describing the central tendency of data. Other
concepts of mean are also important and are discussed below.

The Weighted Mean

In the arithmetic mean, all observations are equally weighted by the factor 1/n. In working with
portfolios, we need the more general concept of weighted mean to allow different weights on
different observations. The formula for the weighted mean is:
𝑛
̅̅̅̅
𝑋𝑤 = ∑ 𝑤𝑖 𝑋𝑖
𝑖=1

where the sum of the weights equals 1; that is ∑𝑛𝑖=1 𝑤𝑖 = 1

Consider an investor with a portfolio of three stocks. 40 is invested in A, 60 in B and 100 in C.

If returns were 5% on A, 7% on B and 9% on C, we can compute the portfolio return by using
the weighted mean: (40/200) x 5% + (60/200) x 5% + (100/200) x 9% = 7%

The Geometric Mean

The general formula for calculating the geometric mean is:

G =(X1 X2 X3 … Xn)1/n with Xi ≥ 0 for i =1, 2,… n.

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As an example, the geometric mean of 7, 8 and 9 will be: (7 x 8 x 9)1/3 = 7.93. The most
common application of the geometric mean is to calculate the average return of an investment.
The formula is:

𝐑 𝐆 =[(1+R1)(1+R2)…….(1+Rn)]1/n – 1

We will illustrate the use of this formula through a simple scenario: For a given stock the return
over the last four periods is: 10%, 8%, -5% and 2%. The geometric mean is calculated as:

[(1 + 0.10)(1 + 0.08)(1 – 0.05)(1 + 0.02)]1/4 – 1 = 0.0358 = 3.58%

Given the returns shown above, $1.00 invested at the start of period 1 grew to: $1.00 x 1.10 x
1.08 x 0.95 x 1.02 = 1.151. If the investment had grown at 3.58% every period, $1.00 invested at
the start of period 1 would have increased to: $1.00 x 1.0358 x 1.0358 x 1.0358 x 1.0358 =
1.151. As expected, both scenarios give the same answer. 3.58% is simply the average growth
rate per period.

The geometric mean is always less than or equal to the arithmetic mean. The only time that the
two means will be equal is when there is no variability in the observations i.e. when all the
observations are the same.

Note: In the reading on Discounted Cash Flow Applications we used the geometric mean to
calculate the time-weighted rate of return.

The Harmonic Mean

The harmonic mean is a special type of weighted mean in which an observation’s weight is
inversely proportional to its magnitude. The formula for a harmonic mean is:
𝑛
1
𝑋𝐻 = 𝑛 / ∑ ( )
𝑋𝑖
𝑖=1

with Xi > 0 for i = 1,2, … n, and n is the number of observations.

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This concept can be applied when we invest the same amount every month in a particular stock
and want to calculate the average purchase price. Suppose an investor purchases $1,000 of a
security each month for three months. The share prices are $10, $15 and $20 at the three
purchase dates. The average purchase price is simply the harmonic mean of 10, 15 and 20. The
harmonic mean is: 3 / (1/10 + 1/15 + 1/20) = 13.85.

The harmonic mean is generally less than the geometric mean, which is in turn less than the
arithmetic mean. To illustrate this fact take three numbers: 10, 15, and 20. It has just been shown
that the harmonic mean is 13.85. The geometric mean is (10 x 15 x 20)1/3 = 14.42. The arithmetic
mean is simply 15. If all the observations in a dataset are the same then the three means are the
same.

6. Other Measures of Location: Quantiles

A quantile is a value at or below which a stated fraction of the data lies.

6.1 Quartiles, Quintiles, Deciles and Percentiles

Quartiles divide the distribution into quarters, quintiles into fifths, deciles into tenths, and
percentiles into hundredths. Given a set of observations, the yth percentile is the value at or below
which y percent of observations lie. Often we need to approximate the value of a percentile. To
do so we arrange the data in ascending order and locate the position of the percentile within the
set of observations. We then determine (or estimate) the value associated with that position. The
formula to calculate the percentile in such a way is:

Ly = (n+1) y /100

Where y is the percentage point at which we are dividing the distribution, n is the number of
observations and Ly is the location (L) of the percentile (Py) in an array sorted in ascending order.
Some important points to remember are:

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 When the location, Ly, is a whole number, the location corresponds to an actual
observation.
 When Ly is not a whole number or integer, Ly lies between the two closest integer
numbers (one above and one below) and we use linear interpolation between those two
places to determine Py.

Worked Example 3: Calculating Percentiles

Given below is the return data on 20 mutual funds arranged in ascending order.
Number 1 2 3 4 5 6 7 8 9 10

Return in % 1.25 1.70 1.75 1.85 1.98 1.99 2.05 2.40 2.49 2.60

Number 11 12 13 14 15 16 17 18 19 20

Return in % 2.90 3.00 3.24 3.75 3.90 1.99 2.05 2.40 2.49 2.60

At a given percentile, y = 10%, with n = 20 and the data sorted in ascending order, the location
of the observation is given by:

L = (20 + 1) (10/100) = 2.1

10

With a small data set, such as this one, the location calculated using the above formula is
approximate. As the data set becomes larger, the formula gives a more precise location.

6.2 Quantiles in Investment Practice

Quantiles can be used to rank the performance of portfolios and even investment managers. In
investment research, analysts often refer to the set of companies with returns falling below the
10th percentile cutoff point as the bottom return decile. It is also common to place funds in
quartiles based on performance in a given period. A top quartile fund means that relative to
comparable funds, the performance of this fund is in the top 25%.

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7. Measures of Dispersion

Dispersion is the variability around the central tendency. Absolute dispersion is the amount of
variability present without comparison to any reference point or benchmark. Range, mean
absolute deviation, variance, and standard deviation are all examples of absolute dispersion.

7.1 The Range

The range is the difference between the maximum and minimum values in a data set. Consider
the same data set we used before: 2%, 5%, 4%, 7%, 8%, 8%, 12%, 10%, 8%, and 5%. Here the
maximum return is 12% and the minimum return is 4%. The range is 12% – 4% = 8%. The range
is easy to calculate but uses only two pieces of information from the distribution. It cannot tell us
how the data are distributed i.e. the shape of the distribution.

7.2 The Mean Absolute Deviation

The dispersion around the mean is a fundamental piece of information used in statistics.
However, if we take an arithmetic average of the deviations around the mean, we encounter a
problem: such an arithmetic average always sums to 0. One solution to this is to examine the
absolute deviations around the mean as in the mean absolute deviation.

𝑀𝐴𝐷 = [∑|𝑋𝑖 − 𝑋̅|] /𝑛

𝑖=1

where X is the sample mean and n is the number of observations in the sample.

Consider the following data set: 8, 12, 10, 8 and 5.

X = (8 + 12 + 10 + 8 + 5)/5 = 8.6
|8 − 8.6| + |12 − 8.6| + |10 − 8.6| + |8 − 8.6| + |5 − 8.6|
𝑀𝐴𝐷 =
5
= (0.6 + 3.4 + 1.4 + 0.6 + 3.6) / 5 = 1.92

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7.3 Population Variance and Population Standard Deviation

Variance is defined as the average of the squared deviations around the mean. Standard deviation
is the positive square root of the variance.

Population variance is the arithmetic average of the squared deviations around the mean.
𝑁

𝜎 2 = ∑(𝑋𝑖 − 𝜇) 2 / 𝑁
𝑖=0

where µ is the population mean and N is the size of the population.

For the dataset: 2%, 5%, 4%, 7%, 8%, 8%, 12%, 10%, 8%, and 5%, the variance is given by:
[(2−6.9)2 +(5−6.9)2 +(4−6.9)2 +(7−6.9)2 +(8−6.9)2 +(8−6.9)2 +(12−6.9)2 +(10−6.9)2 +(8−6.9)2 + (5−6.9)2 ]
𝜎2 = 10
2
𝜎 = 7.89

Because variance is measured in squared units, we need a way to return to the original units. We
can solve this problem by using standard deviation, the square root of the variance. The
population standard deviation is defined as the positive square root of the population variance.
For the data given above, 𝜎 = √7.89 = 2.81%.

Both the population variance and standard deviation are examples of parameters of a distribution.
We often do not know the mean of a population of interest. We then estimate the population
mean with a mean from a sample drawn from the population. Next, we calculate the sample
variance and standard deviation.

7.4 Sample Variance and Sample Standard Deviation

When we deal with samples, the summary measures are called statistics. The statistic that
measures dispersion in a sample is called the sample variance.
𝑛

𝑠 2 = ∑(𝑋𝑖 − 𝑋̅ ) 2 / (𝑛 − 1)
𝑖=0

where 𝑋̅ is the sample mean and n is the number of observations in the sample.
The steps to calculate a sample variance are:
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 Calculate the same mean, 𝑋̅

 Calculate each observation’s squared deviation from the sample mean, (𝑋𝑖 − 𝑋̅ ) 2
 Sum the squared deviations from the mean: ∑𝑛𝑖=0(𝑋𝑖 − 𝑋̅ ) 2
 Divide the sum of squared deviations from the mean by n-1:
𝑛

∑(𝑋𝑖 − 𝑋̅ ) 2 / (𝑛 − 1)
𝑖=0

By using n - 1 (rather than n) as the divisor, we improve the statistical properties of the sample
variance.

Consider the following data set: 8, 12, 10, 8 and 5. The sample variance is calculated as follows:

2
[(8 − 8.6)2 + (12 − 8.6)2 + (10 − 8.6)2 + (8 − 8.6)2 + (5 − 8.6)2 ]
𝑠 =
5−1
𝑠 2 = 6.80%

The sample standard deviation is the positive square root of the sample variance. For the sample
data given above, 𝑠 = √6.80 = 2.61%.

The population and sample standard deviation can easily be computed using a financial
calculator. Assume the following data set: 10%, -5%, 10%, 25%, the calculator key strokes are
show below:

Keystrokes Explanation Display

[2nd] [DATA] Enter data entry mode

[2nd] [CLR WRK] Clear data registers X01

10 [ENTER] X01 = 10

[↓] [↓] 5+/- [ENTER] X02 = -5

[↓] [↓] 10 [ENTER] X03 = 10

[↓] [↓] 25 [ENTER] X04 = 25

[2nd] [STAT] [ENTER] Puts calculator into stats mode.

[2nd] [SET] Press repeatedly till you see  1-V

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Keystrokes Explanation Display

[↓] Number of data points N=4

[↓] Mean X = 10

[↓] Sample standard deviation Sx = 12.25

[↓] Population standard deviation σx = 10.61

Notice that the calculator gives both the sample and the population standard deviation. On the
exam we will have to determine whether we are dealing with population or sample data.

7.5 Semivariance, Semideviation, and Related Concepts

Note: Semivariance and semideviation are not emphasized in the learning outcomes and have a
very low probability of being tested on the Level I exam. Nevertheless, a brief explanation is
given below.

Variance and standard deviation of returns take account of returns above and below the mean,
but investors are concerned only with downside risk, for example returns below the mean. As a
result, analysts have developed semivariance, semideviation and related dispersion measures that
focus on downside risk. Semivariance is defined as the average squared deviation below the
mean. Semideviation is the positive square root of semivariance. When return distributions are
symmetric, semivariance and variance are effectively equivalent. For asymmetric distributions,
variance and semivariance rank prospects’ risk differently.

7.6 Chebyshev’s Inequality

According to Chebyshev’s inequality, the proportion of the observations within k standard

deviations of the arithmetic mean is at least 1 - 1/k2 for all k > 1. To find out what percent of the
observations must be within 2 standard deviations of the mean we simply plug into the formula
and get: 1 – 1/22 = 1 – ¼ = 0.75 = 75%. Hence at least 75% of the data will be between 2
standard deviations of the mean. To understand this concept, consider a distribution with a mean
value of 10 and a standard deviation of 3. For this distribution at least 75% of the data will be

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between 4 and 16. Note that 4 is two standard deviations (2 x 3) less than the mean (10) and 16 is
two standard deviations greater than the mean.

Plugging in a value of k = 3 in Chebyshev’s inequality shows us that at least 89% of the

population data will lie within three standard deviations of the mean.

Chebyshev’s inequality holds for samples and populations, and for discrete and continuous data
regardless of the shape of the distribution.

Worked Example 4: Chebyshev’s Inequality

Note: This example has been reproduced from the curriculum.

The arithmetic mean monthly return and standard deviation of monthly returns on the S&P 500
were 0.97 percent and 5.65 percent, respectively, during the 1926–2002 period, totaling 924
monthly observations. Using this information, address the following:

1. Calculate the endpoints of the interval that must contain at least 75 percent of monthly
returns according to Chebyshev’s inequality.
2. What are the minimum and maximum number of observations that must lie in the interval
computed in Part 1, according to Chebyshev’s inequality?

Solution to 1:

According to Chebyshev’s inequality, at least 75 percent of the observations must lie within two
standard deviations of the mean, X ± 2s. For the monthly S&P 500 return series, we have 0.97%
± 2(5.65%) = 0.97% ± 11.30%. Thus the lower endpoint of the interval that must contain at least
75 percent of the observations is 0.97% − 11.30% = −10.33%, and the upper endpoint is 0.97% +
11.30% = 12.27%.

Solution to 2:

For a sample size of 924, at least 0.75(924) = 693 observations must lie in the interval from
−10.33% to 12.27% that we computed in Part 1.

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7.7 Coefficient of Variation

Sometimes we may find it difficult to interpret what the standard deviation means in terms of the
relative degree of variability of different data sets. This can be because the data sets are
significantly different or because the data sets have different units of measurement. The
coefficient of variation can be useful in such situations. It is the ratio of the standard deviation of
a set of observations to their mean value.

𝐶𝑉 = 𝑠/𝑋̅

When the observations are returns, the coefficient of variation measures the amount of risk
(standard deviation) per unit of mean return. Hence, it allows us to directly compare dispersion
across different data sets. Consider a simple example. Investment A has a mean return of 7% and
a standard deviation of 5%. Investment B has a mean return of 12% and a standard deviation of
7%. The coefficients of variation can be calculated as follows:
5%
𝐶𝑉𝐴 = = 0.71
7%
7%
𝐶𝑉𝐵 = = 0.58
12%
This metric shows that Investment A is more risky than Investment B.

7.8 The Sharpe Ratio

If we use an inverse of the CV, we get a measure for the return per unit of risk of an investment.
A more precise return-risk measure is the Sharpe ratio. The Sharpe ratio is the ratio of excess
return to standard deviation of return for a portfolio, p. Excess return refers to the return above
the risk free rate. The formula for calculating the Sharpe ratio is:
𝑅̅𝑝 − 𝑅̅𝐹
𝑆𝑝 =
𝑠𝑝
where
𝑅̅𝑝 = Mean return to the portfolio
𝑅̅𝐹 = Mean return to a risk-free asset
𝑠𝑝 = Standard deviation of return on the portfolio

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Worked Example 5: Calculating Sharpe Ratio

The table below provides data for two portfolios. Given that the mean annual risk free rate is
10.5%, which portfolio has the higher Sharpe ratio?

Portfolio Arithmetic mean Variance of (%)

return (%)
Portfolio A 16.4% 4.9%

Portfolio B 12.6% 3.5%

Solution:
16.4 − 10.5
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐴: = 2.665
√4.9

12.6 − 10.5
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐵: = 1.122
√3.5

Portfolio A offers a higher excess return per unit of risk relative to Portfolio B.

8. Symmetry and Skewness in Return Distributions

While mean and variance are useful, we need to go beyond measures of central tendency and
dispersion to reveal other important characteristics of a distribution. One important characteristic
of interest to analysts is the degree of symmetry in return distributions. If a return distribution is
symmetrical about its mean, then each side of the distribution is a mirror image of the other.
A distribution that is not symmetrical is called skewed. A return distribution with positive skew
has frequent small losses and a few extreme gains. A return distribution with negative skew has
frequent small gains and a few extreme losses. The figures below show these distributions.

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Distribution Skewed to the Right (Positively Skewed) Distribution Skewed to the Left (Negatively Skewed)

For the positively skewed unimodal distribution, the mode is less than the median, which is less
than the mean. For the negatively skewed unimodal distribution, the mean is less than the
median, which is less than the mode. All else equal, if investment returns have negative skew,
that is considered more risky than symmetric and positively skewed distributions. A negative
skew implies a fat left tail and hence a relatively high probability of extreme losses. A skewness
of greater than 0.5 or less than -0.5 is considered significant.

The curriculum presents formulas for calculating skewness. However, it is extremely unlikely
that we’ll be tested on these formulas at Level I. Consequently the formulas are not being
reproduced in these notes.

9. Kurtosis in Return Distributions

A return distribution might differ from a normal distribution by having more returns clustered
closely around the mean (being more peaked) and more returns with large deviations from the
mean (having fatter tails). Kurtosis is the statistical measure that tells us when a distribution is
more or less peaked than a normal distribution. A distribution that is more peaked than normal is
called leptokurtic. A distribution that is less peaked than normal is called platykurtic. A
distribution identical to the normal distribution is called mesokurtic. Examples of a mesokurtic
distribution (normal) and leptokurtic distribution (fat tails) are shown below.

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For all normal distributions, kurtosis is equal to 3. Excess kurtosis is kurtosis minus 3. Hence, a
mesokurtic distribution has excess kurtosis equal to 0. A leptokurtic distribution has excess
kurtosis greater than 0, and a platykurtic distribution has excess kurtosis less than 0. For a sample
of 100 or larger taken from a normal distribution, a sample excess kurtosis of 1.0 or larger would
be considered unusually large.

A leptokurtic distribution is considered more risky than a normal distribution because it has fatter
tails and hence a higher probability of extreme losses.

10. Using Geometric and Arithmetic Means

For reporting historical returns (time series data), the geometric mean is attractive because it is
the rate of growth of return we would have had to earn each year to match the actual, cumulative
investment performance. Consequently, to estimate the average returns over more than one
period, we should use the geometric mean because it captures how the total returns are linked
over time. On the other hand, if we want to estimate the average return of multiple investments
over a one-period horizon (cross-sectional data), we should use the arithmetic mean.

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Summary
Note: This summary has been adapted from the CFA Program curriculum.

 A population is defined as all members of a specified group. A sample is a subset of a

population.
 A parameter is any descriptive measure of a population. A sample statistic (statistic, for
short) is a quantity computed from or used to describe a sample.
 Data measurements are taken using one of the four major scales: nominal, ordinal, interval,
or ratio. Nominal scales categorize data but do not rank them. Ordinal scales sort data into
categories that are ordered with respect to some characteristic. Interval scales provide not
only ranking but also assurance that the differences between scale values are equal. Ratio
scales have all the characteristics of interval scales as well as a true zero point as the origin.
The scale on which data are measured determines the type of analysis that can be performed
on the data.
 A frequency distribution is a tabular display of data summarized into a relatively small
number of intervals. Frequency distributions permit us to evaluate how data are distributed.
 The relative frequency of observations in an interval is the number of observations in the
interval divided by the total number of observations. The cumulative relative frequency
cumulates (adds up) the relative frequencies as we move from the first interval to the last,
thus giving the fraction of the observations that are less than the upper limit of each interval.
 A histogram is a bar chart of data that have been grouped into a frequency distribution. A
frequency polygon is a graph of frequency distributions obtained by drawing straight lines
joining successive points representing the class frequencies.
 Sample statistics such as measures of central tendency, measures of dispersion, skewness,
and kurtosis help with investment analysis, particularly in making probabilistic statements
about returns.
 Measures of central tendency specify where data are centered and include the (arithmetic)
mean, median, and mode (most frequently occurring value). The mean is the sum of the
observations divided by the number of observations. The median is the value of the middle
item (or the mean of the values of the two middle items) when the items in a set are sorted
into ascending or descending order. The mean is the most frequently used measure of central

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tendency. The median is not influenced by extreme values and is most useful in the case of
skewed distributions. The mode is the only measure of central tendency that can be used with
nominal data.
 A portfolio’s return is a weighted mean return computed from the returns on the individual
assets, where the weight applied to each asset’s return is the fraction of the portfolio invested
in that asset.
 The geometric mean, G, of a set of observations X1, X2, . . . Xn is G =(X1X2X3…Xn)1/n
 The geometric mean is especially important in reporting compound growth rates for time
series data. When calculating the average return over a given period the following formula is
used:
R G =[(1+R1) (1+R2)… (1+Rn)]1/n – 1
 The harmonic mean is a special type of weighted mean in which an observation’s weight is
inversely proportional to its magnitude. The formula is:
𝑛
1
𝑋𝐻 = 𝑛 / ∑ ∑( )
𝑋𝑖
𝑖=1

 For any data set where the values are not the same, arithmetic mean > geometric mean >
harmonic mean.
 Quantiles such as the median, quartiles, quintiles, deciles, and percentiles are location
parameters that divide a distribution into halves, quarters, fifths, tenths, and hundredths,
respectively.
 Dispersion measures such as the variance, standard deviation, and mean absolute deviation
(MAD) describe the variability of outcomes around the arithmetic mean.
 Range is defined as the maximum value minus the minimum value. Range has only a limited
scope because it uses information from only two observations.
 MAD is average of the absolute deviation from the mean. This can be expressed as:
𝑛

𝑀𝐴𝐷 = [∑|𝑋𝑖 − 𝑋̅|] /𝑛

𝑖=1

 The variance is the average of the squared deviations around the mean, and the standard
deviation is the positive square root of variance. In computing sample variance (s2) and

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sample standard deviation, the average squared deviation is computed using a divisor equal
to the sample size minus 1.
 According to Chebyshev’s inequality, the proportion of the observations within k standard
deviations of the arithmetic mean is at least 1 − 1/k2 for all k > 1. Chebyshev’s inequality
permits us to make probabilistic statements about the proportion of observations within
various intervals around the mean for any distribution with finite variance. As a result of
Chebyshev’s inequality, a two-standard-deviation interval around the mean must contain at
least 75 percent of the observations, and a three-standard-deviation interval around the mean
must contain at least 89 percent of the observations, no matter how the data are distributed.
 The coefficient of variation, CV, is the ratio of the standard deviation of a set of observations
to their mean value. A scale-free measure of relative dispersion, by expressing the magnitude
of variation among observations relative to their average size, the CV permits direct
comparisons of dispersion across different data sets.
 The Sharpe ratio for a portfolio, p, based on historical returns, is defined as: (return on
portfolio – risk free rate) / standard deviation of portfolio. It gives the excess return per unit
of risk.
 Skew describes the degree to which a distribution is not symmetric about its mean. A return
distribution with positive skewness has frequent small losses and a few extreme gains. A
return distribution with negative skewness has frequent small gains and a few extreme losses.
Zero skewness indicates a symmetric distribution of returns.
 Kurtosis measures the peakness of a distribution and provides information about the
probability of extreme outcomes. A distribution that is more peaked than the normal
distribution is called leptokurtic; a distribution that is less peaked than the normal distribution
is called platykurtic; and a distribution identical to the normal distribution in this respect is
called mesokurtic. Excess kurtosis is kurtosis minus 3, the value of kurtosis for all normal
distributions.

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Next Steps

 Make sure you are comfortable using the financial calculator for statistical calculations.
 Work through the examples presented in the curriculum.
 Solve the practice problems in the curriculum.
 Solve the IFT Practice Questions associated with this reading.
 Review the learning outcomes presented in the curriculum. Make sure that you can perform
that actions implied by learning outcome.

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