We all know that stock market returns are not normally distributed. Instead, we think of them as having fat tails (i.e. extreme events happen more frequently than expected). As you can see, on an annual scale, market returns are essentially random and follow the normal distribution relatively well.

Does a normal distribution describe asset returns?

One of the most popular choices for modeling the properties of asset returns is the normal distribution. The normal distribution offers several advantages in this case: It is a continuous distribution, defined for an infinite number of values.

Why the assumption that returns are normally distributed is important in the portfolio theory?

Most basic theory concerning asset allocation, such as Modern Portfolio Theory, assumes that returns are normally distributed. This allows a great deal of analytical progress to be made since adding random numbers from normal distributions gives you another normal distribution.

How is normal distribution used in stock market?

The normal distribution is symmetrical around the central value with half the values on each side. A lot of real-life examples fit the bell curve distribution: In finance, changes in the log values of forex rates, price indices, and stock prices are assumed to be normally distributed.

What are the two components of a total holding period return?

Describe the two components of a total holding period return. The total holding period return on an investment consists of a capital appreciation component and an income component.

How do you check if returns are normally distributed?

For quick and visual identification of a normal distribution, use a QQ plot if you have only one variable to look at and a Box Plot if you have many. Use a histogram if you need to present your results to a non-statistical public. As a statistical test to confirm your hypothesis, use the Shapiro Wilk test.