What Is a Bell Curve?
A bell curve is the most common type of distribution for a variable and is thus considered to be a normal distribution. The term "bell curve" originates from the fact that the graph used to depict a normal distribution consists of a bell-shaped line. The highest point on the curve, or the top of the bell, represents the most probable event in a series of data, while all other possible occurrences are equally distributed around the most probable event, creating a downward-sloping line on each side of the peak.
- A bell curve is a graph that is considered to be a normal distribution.
- The top of the curve shows the most likely event out of the data collected.
- After the mean is calculated, standard deviations are figured.
- Standard deviations that depict the returns of a security are known as volatility.
- When making assumptions about a stock’s potential future returns, investors look at the normal probability distribution of its past returns.
What Does a Bell Curve Tell You?
The term bell curve is used to describe a graphical depiction of a normal probability distribution, whose underlying standard deviations from the mean create the curved bell shape. A standard deviation is a measurement used to quantify the variability of data dispersion, in a set of given values. The "mean" refers to the average of all data points in the data set or sequence.
Financial analysts and investors often use a normal probability distribution when analyzing the returns of a security or of overall market sensitivity. In finance, standard deviations that depict the returns of a security are known as volatility.
For example, stocks that display a bell curve usually are blue-chip stocks and ones that have lower volatility and more predictable behavioral patterns. Investors use the normal probability distribution of a stock's past returns to make assumptions regarding expected future returns.
In addition to teachers who use a bell curve when comparing test scores, the bell curve is often also used in the world of statistics where it can be widely applied. Bell curves are also sometimes employed in performance management, placing employees who perform their job in an average fashion in the normal distribution of the graph. The high performers and the lowest performers are represented on either side with the dropping slope. It can be useful to larger companies when doing performance reviews or when making managerial decisions.
Example of How to Use a Bell Curve
A bell curve uses standard deviations, which are calculated after the mean is calculated, and represent a percentage of the total data collected. On a bell curve, for example, if 100 test scores are collected and used in a normal probability distribution, 68% of those test scores should fall within one standard deviation above or below the mean. Moving two standard deviations away from the mean should include 95% of the 100 test scores collected. Moving three standard deviations away from the mean should represent 99.7% of the scores.
Test scores that are extreme outliers, such as a score of 100 or 0, would be considered long-tail data points that consequently lie squarely outside of the three standard deviation range.
A bell curve should be symmetrical in shape.
The Difference Between a Bell Curve and Non-Normal Distributions
The normal probability distribution assumption doesn’t always hold true in the financial world, however. It is feasible for stocks and other securities to sometimes display non-normal distributions that fail to resemble a bell curve.
Non-normal distributions have fatter tails than a bell curve (normal probability) distribution. A fatter tail that skews negative signals to investors that there is a greater probability of negative returns.
Limitations of Using a Bell Curve
Grading or assessing performance using a bell curve forces groups of people to be categorized as poor, average, or good. For smaller groups, having to categorize a set number of individuals in each category to fit a bell curve will do a disservice to the individuals. As sometimes, they may all be just average or even good workers or students, but given the need to fit their rating or grades to a bell curve, some individuals are forced into the poor group.