Question

e) Why is the normal distribution so popular in investment analysis?

Answer 1

An important point to note is that simple predictive models are usually the most used models. This is due to the fact that they can be explained and are well-understood. Now to add to this point; normal distribution is simple and hence its simplicity makes it extremely popular. The use of normal distribution in financial models is a convenient simplification, as it allows the application of a multitude of mathematical and statistical methods. The normal distribution is characteristic of ideally random processes. However, it’s used as an approximation and a simplification in many cases where a better alternative is not available. Because it's simple and easy to understand and help to create a financial theoretical background. Using the normal distribution facilitates a lot of statistical tools that simplifies work. We use easy and simple as if they were interchangeable. Simple is elegant. Simple is sophisticated. Adding complexity is always easy. Finding a simple elegant solution is invariably hard. Gaussian distribution paints an easy picture of the world. The same breed of academics who came up with Central Limit Theorem devised Efficient Market Hypothesis and CAPM. They settled for easy. They did not have to work hard enough to find something simple. This was a simplistic approach to analyze the numbers without the computing power that we take for granted now. We still continue to use this model - and that could be because it is easier to explain to people without a high level of technical knowledge. For some reason, people seem to relate to the shape of a bell curve.

Finance theories only begin from a normal distribution assumption because of the simplicity in the approach and to develop the basic theoretical structure but the story hardly ends there.