Question

1. Describe a normal distribution and explain why it is common to use it to explain investment return and risk. Give example(s) as appropriate. What is/are the major problem(s) / limitation(s) to use it in real life financial scenarios ?

Answer 1

A normal distribution is a probability distribution that is symmetric about the mean, showing that data near the mean are more frequent in occurrence than data far from the mean. In graph form, normal distribution will appear as a bell curve.

It is defined by the mean and the standard deviation. The mean is the expected return and the standard deviation is the risk. Normal distribution is used to explain investment return as the mean and standard deviation are good representations of expectations and risk respectively.

In real life, returns are not entirely normally distributed and have fatter tails, which imply that extreme events would occur more frequently than implied by the normal distribution.