Showing posts with label central limit theorem. Show all posts
Showing posts with label central limit theorem. Show all posts

Monday, July 31, 2023

Essential business knowledge: the Central Limit Theorem

Knowing the Central Limit Theorem means avoiding costly mistakes

I've spoken to well-meaning analysts who've made significant mistakes because they don't understand the implications of one of the core principles of statistics; the Central Limit Theorem (CLT). These errors weren't trivial either, they affected salesperson compensation and the analysis of A/B tests. More personally, I've interviewed experienced candidates who made fundamental blunders because they didn't understand what this theorem implies.

The CLT is why the mean and standard deviation work pretty much all the time but it's also why they only work when the sample size is "big enough". It's why when you're estimating the population mean it's important to have as large a sample size as you can. It's why we use the Student's t-test for small sample sizes and why other tests are appropriate for large sample sizes. 

In this blog post, I'm going to explain what the CLT is, some of the theory behind it (at a simple level), and how it drives key business statistics. Because I'm trying to communicate some fundamental ideas, I'm going to be imprecise in my language at first and add more precision as I develop the core ideas. As a bonus, I'll throw in a different version of the CLT that has some lesser-known consequences.

How we use a few numbers to represent a lot of numbers

In all areas of life, we use one or two numbers to represent lots of numbers. For example, we talk about the average value of sales, the average number of goals scored per match, average salaries, average life expectancy, and so on. Usually, but not always, we get these numbers through some form of sampling, for example, we might run a salary survey asking thousands of people their salary, and from that data work out a mean (a sampling mean). Technically, the average is something mathematicians call a "measure of central tendency" which we'll come back to later.

We know not everyone will earn the mean salary and that in reality, salaries are spread out. We express the spread of data using the standard deviation. More technically, we use something called a confidence interval which is based on the standard deviation. The standard deviation (or confidence interval) is a measure of how close we think our sampling mean is to the true (population) mean.

In practice, we use standard formula for the mean and standard deviation. These are available as standard functions in spreadsheets and programming languages. Mathematically, this is how they're expressed.

\[sample\; mean\; \bar{x}= \frac{1}{N}\sum_{i=0}^{N}x_i\]

\[sample\; standard\; deviation\; s_N = \sqrt{\frac{1}{N} \sum_{i=0}^{N} {\left ( x_i - \bar{x} \right )} ^ 2 } \]

All of this seems like standard stuff, but there's a reason why it's standard, and that's the central limit theorem (CLT).


Let's look at three different data sets with different distributions: uniform, Poisson, and power law as shown in the charts below.

These data sets are very, very different. Surely we have to have different averaging and standard deviation processes for different distributions? Because of the CLT, the answer is no. 

In the real world, we sample from populations and take an average (for example, using a salary survey), so let's do that here. To get going, let's take 100 samples from each distribution and work out a sample mean. We'll do this 10,000 times so we get some kind of estimate for how spread out our sample means are.

The top charts show the original population distribution and the bottom charts show the result of this sampling means process. What do you notice?

The distribution of the sampling means is a normal distribution regardless of the underlying distribution.

This is a very, very simplified version of the CLT and it has some profound consequences, the most important of which is that we can use the same averaging and standard deviation functions all the time.

Some gentle theory

Proving the CLT is very advanced and I'm not going to do that here. I am going to show you through some charts what happens as we increase the sample size.

Imagine I start with a uniform random distribution like the one below. 

I want to know the mean value, so I take some samples and work out a mean for my samples. I do this lots of times and work out a distribution for my mean. Here's what the results look like for a sample size of 2, 3,...10,...20,...30,...40. 

As the sample size gets bigger, the distribution of the means gets closer to a normal distribution. It's important to note that the width of the curve gets narrower with increasing sample size. Once the distribution is "close enough" to the normal distribution (typically, around a sample size of 30), you can use normal distribution methods like the mean and standard deviation.

The standard deviation is a measure of the width of the normal distribution. For small sample sizes, the standard deviation underestimates the width of the distribution, which has important consequences.

Of course, you can do this with almost any underlying distribution, I'm just using a uniform distribution because it's easier to show the results 

Implications for averages

The charts above show how the distribution of the means changes with sample size. At low sample sizes, there are a lot more "extreme" values as the difference between the sample sizes of 2 and 40 shows.  Bear in mind, the width of the distribution is an estimate of the uncertainty in our measurement of the mean.

For small sample sizes, the mean is a poor estimator of the "average" value; it's extremely prone to outliers as the shape of the charts above indicates. There are two choices to fix the problem: either increase the sample size to about 30 or more (which often isn't possible) or use the median instead (the median is much less prone to outliers, but it's harder to calculate).

The standard deviation (and the related confidence interval) is a measure of the uncertainty in the mean value. Once again, it's sensitive to outliers. For small sample sizes, the standard deviation is a poor estimator for the width of the distribution. There are two choices to fix the problem, either increase the sample size to 30 or more (which often isn't possible) or use quartiles instead (for example, the interquartile range, IQR).

If this sounds theoretical, let me bring things down to earth with an example. Imagine you're evaluating salesperson performance based on deals closed in a quarter. In B2B sales, it's rare for a rep to make 30 sales in a quarter, in fact, even half that number might be an outstanding achievement. With a small number of samples, the distribution is very much not normal, and as we've seen in the charts above, it's prone to outliers. So an analysis based on mean sales with a standard deviation isn't a good idea; sales data is notorious for outliers. A much better analysis is the median and IQR. This very much matters if you're using this analysis to compare rep performance.

Implications for statistical tests

A hundred years ago, there were very few large-scale tests, for example, medical tests typically involved small numbers of people. As I showed above, for small sample sizes the CLT doesn't apply. That's why Gosset developed the Student's t-distribution: the sample sizes were too small for the CLT to kick in, so he needed a rigorous analysis procedure to account for the wider-than-normal distributions. The point is, the Student's t-distribution applies when sample sizes are below about 30.

Roll forward 100 years and we're now doing retail A/B testing with tens of thousands of samples or more. In large-scale A/B tests, the z-test is a more appropriate test. Let me put this bluntly: why would you use a test specifically designed for small sample sizes when you have tens of thousands of samples?

It's not exactly wrong to use the Student's t-test for large sample sizes, it's just dumb. The special features of the Student's t-test that enable it to work with small sample sizes become irrelevant. It's a bit like using a spanner as a hammer; if you were paying someone to do construction work on your house and they were using the wrong tool for something simple, would you trust them with something complex?

I've asked about statistical tests at interview and I've been surprised at the response. Many candidates have immediately said Student's t as a knee-jerk response (which is forgivable). Many candidates didn't even know why Student's t was developed and its limitations (not forgivable for senior analytical roles). One or two even insisted that Student's t would still be a good choice even for sample sizes into the hundreds of thousands. It's very hard to progress candidates who insist on using the wrong approach even after it's been pointed out to them.

As a practical matter, you need to know what statistical tools you have available and their limitations.

Implications for sample sizes

I've blithely said that the CLT applies above a sample size of 30. For "most" distributions, a sample size of about 30 is a reasonable rule-of-thumb, but there's no theory behind it. There are cases where a sample size of 30 is insufficient. 

At the time of writing, there's a discussion on the internet about precisely this point. There's a popular article on LessWrong that illustrates how quickly convergence to the normal can happen: but there's also a counter article that talks about cases where convergence can take much longer:

The takeaway from this discussion is straightforward. Most of the time, using a sample size of 30 is good enough for the CLT to kick-in, but occasionally you need larger sample sizes. A good way to test this is to use larger sample sizes and see if there's any trend in the data. 

General implications

The CLT is a double-edged sword: it enables us to use the same averaging processes regardless of the underlying distribution, but it also lulls us into a false sense of security and analysts have made blunders as a result.

Any data that's been through an averaging process will tend to follow a normal distribution. For example, if you were analyzing average school test scores you should expect them to follow a normal distribution, similarly for transaction values by retail stores, and so on. I've seen data scientists claim brilliant data insights by announcing their data is normally distributed, but they got it through an averaging process, so of course it was normally distributed. 

The CLT is one of the reasons why the normal distribution is so prevalent, but it's not the only reason and of course, not all data is normally distributed. I've seen junior analysts make mistakes because they've assumed their data is normally distributed when it wasn't. 

A little more rigor

I've been deliberately loose in my description of the CLT so far so I can explain the general idea. Let's get more rigorous so we can dig into this a bit more. Let's deal with some terminology first.

Central tendency

In statistics, there's something called a "central tendency" which is a measurement that summarizes a set of data by giving a middle or central value. This central value is often called the average. More formally, there are three common measures of central tendency:

  • The mode. This is the value that occurs most often.
  • The median. Rank order the data and this is the middle value.
  • The mean. Sum up all the data and divide by the number of values.

These three measures of central tendency have different properties, different advantages, and different disadvantages. As an analyst, you should know what they are.

(Depending on where you were educated, there might be some language issues here. My American friends tell me that in the US, the term "average" is always a synonym for the mean, in Britain, the term "average" can be the mean, median, or mode but is most often the mean.)

For symmetrical distributions, like the normal distribution, the mean, median, and mode are the same, but that's not the case for non-symmetrical distributions. 

The term "central" in the central limit theorem is referring to the central or "average" value.


The CLT only applies to iid data, which means independent and identically distributed. Here's what iid means. 

  • Each sample in the data is independent of the other samples. This means selecting or removing a sample does not affect the value of another sample.
  • All the samples come from the same probability distribution.

When the CLT doesn't apply

Fortunately for us, the CLT applies to almost all distributions an analyst might come across, but there are exceptions. The underlying distribution must have a finite variance, which rules out using it with distributions like the Cauchy distribution. The samples must be iid as I said before.

A re-statement of the CLT

Given data that's distributed with a finite variance and is iid, if we take n samples, then:

  • as \( n \to \infty \), the sample mean converges to the population mean
  • as \( n \to \infty \), the distribution of the sample means approximates a normal distribution

Note this formulation is in terms of the mean. This version of the CLT also applies to sums because the mean is just the sum divided by a constant (the number of samples).

A different version of the CLT

There's another version of the CLT that's not well-known but does come up from time to time in more advanced analysis. The usual version of the CLT is expressed in terms of means (which is the sum divided by a constant). If instead of taking the sum of the samples, we take their product, then instead of the products tending to a normal distribution they tend to a log-normal distribution. In other words, where we have a quantity created from the product of samples then we should expect it to follow a log-normal distribution. 

What should I take away from all this?

Because of the CLT, the mean and standard deviation mostly work regardless of the underlying distribution. In other words, you don't have to know how your data is distributed to do basic analysis on it. BUT the CLT only kicks in above a certain sample size (which can vary with the underlying distribution but is usually around 30) and there are cases when it doesn't apply. 

You should know what to do when you have a small sample size and know what to watch out for when you're relying on the CLT.

You should also understand that any process that sums (or products) data will lead to a normal distribution (or log-normal).