Simulation is especially helpful when there are several different sources of uncertaintythat interact to produce an outcome.

For example, if we're dealing with uncertain market demand, competitors' pricing, and variable production and raw materials costs at the same time, it can be very difficult to estimate the impacts of these factors -- in combination -- on Net Profit. Monte Carlo simulation can quickly analyze thousands of 'what-if' scenarios, often yielding surprising insights into what can go right, what can go wrong, and what we can do about it. Simulation Analysis The sensitivity analysis and scenario analyses are quite useful to understand the uncertainty of the investment projects. But both approaches suffer from certain weakness. They do not consider the interactions between variables and also, they do not reflect on the profitability of the change in variables. Simulation analysis considers the interactions among variables and profitability of the change in variables. It does not give the projects net present value as a single number rather it computes the profitability distribution of value. The simulation analysis is an extension of scenario analysis. In simulation analysis a computer generates a very large number of scenarios according to the profitability distributions of the variables. The analysis involves the following steps:

First, you should identify variables that influence cash inflows and outflows. For example, when a firm introduces a new product in the market these variables are initial investment, market size, market growth, market share, price, variable costs, fixed costs, product life cycle, and terminal variable. Second, specify the formulae that relative variables. For example, revenue depends on by sales volume and price; sales volume is given by market size, market share, and market growth. Similarly, operating expenses depend on production, sales and variable and fixed costs. Third, indicate the profitability distribution for each variable. Some variables will have more uncertainty than others, For example, it is quite difficult to predict price or market growth with confidence. Fourth, develop a computer programme that randomly selects one variable from the profitability distinction of each variable and uses these values to calculate the projects net present value. The computer generates a large number of such scenarios, calculates net present values and stores them. The stored values are printed as a profitability distribution of the projects values along with the expected value and its standard deviation. The risk-free rate should be used as the discount rate to compute the projects value. Since simulation is performed to account for the risk of the projects cash flows, the discount rate should reflect only the time value of money.

That analysis is a very useful technique for risk analysis. Unfortunately, its practical use is limited because of a number of shortcomings. First, the model becomes quite complex to use because the variable depends are interrelated with each other, and each variable depends on its values in the previous periods as well. Identifying all possible relationships and estimating probability distribution is a difficult task; its time consuming as well as expensive. Second, the

model helps to generating a profitability distribution of the projects net present values. But it does not indicate whether or not the project should be accepted. Third, considers the risk of any project in isolation of other projects. Statistical Techniques for Risk Analysis Statistical techniques are analytical tools for handling risky investments. These techniques, drawing from the fields of mathematics, logic, economics and psychology, enable the decisionmaker to make decisions under risk or uncertainty. The concept of probability is fundamental to the use of the risk analysis techniques. Hoe is probability defined? How are probabilities estimated? How are they used in the risk analysis techniques? How do statistical techniques help in resolving the complex problem of analyzing risk in capital budgeting? We attempt to answer these questions in our posts. Probability defined The most crucial information for the capital budgeting decision is a forecast of future cash flows. A typical forecast is single figure for a period. This referred to as best estimate or most likely forecast. But the questions are: To what extent can one rely this single figure? How is this figure arrived at? Does it reflect risk? In fact, the decision analysis is limited in two ways by this single figure forecast. Firstly, we do not know the changes of this figure actually occurring, i.e. the uncertainty surrounding this figure. In other words, we do not know the range of the forecast and the chance or the probability estimates associated with figures within the range. Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is mean, median or mode. For these reasons, a forecaster should not give just one estimate, but a range of associate probability- a probability distribution. Probability may be described as a measure of someones option about the likelihood that an event will occur. If an event is certain to occur, we say that it has a probability of one of occurring. If an event is certain not to occur, we say that its probability of occurring is zero. Thus, probability of all events to occur lies between zero and one. A probability distribution may consist of a number of estimates. But in the simple form it may consist of only a few estimates. One commonly used form employs only the high, low and best guess estimates, or the optimistic, most likely and pessimistic estimates. Assigning probability The classical probability theory assumes that no statement whatsoever can be made about the probability of any single event. In fact, the classical view holds that one can talk about probability in a very long run sense, given that the occurrence or non-occurrence of the event can

be repeatedly observed over a very large number of times under independent identical situations. Thus, the probability estimate, which is based on a very large number of observations, is known as an objective probability. The classical concept of objective probability is of little use in analyzing investment decision because these decisions are non-respective and hardly made under independent identical conditions over time. As a result, some people opine that it is not very useful to express the forecasters estimates in terms of probability. However, in recent years another view of probability has revived, that is, the personal view, which holds that it makes a great deal of sense to talk about the probability of a single event, without reference to the repeatability, long run frequency concept. Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities.

Standard Deviation as a Measure of Risk The standard deviation essentially reports a fund's volatility, which indicates the tendency of the returns to rise or fall drastically in a short period of time. A security that is volatile is also considered higher risk because its performance may change quickly in either direction at any moment. The standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its mean return, the average return of a fund over a period of time. A fund that has a consistent four-year return of 3%, for example, would have a mean, or average, of 3%. The standard deviation for this fund would then be zero because the fund's return in any given year does not differ from its four-year mean of 3%. On the other hand, a fund that in each of the last four years returned -5%, 17%, 2% and 30% will have a mean return of 11%. The fund will also exhibit a high standard deviation because each year the return of the fund differs from the mean return. This fund is therefore more risky because it fluctuates widely between negative and positive returns within a short period.

To determine how well a fund is maximizing the return received for its volatility, you can compare the fund to another with a similar investment strategy and similar returns. The fund with the lower standard deviation would be more optimal because it is maximizing the return received for the amount of risk acquired.

The standard deviation is often used by investors to measure the risk of a stock or a stock portfolio. The basic idea is that the standard deviation is a measure of volatility: the more a stock's returns vary from the stock's average return, the more volatile the stock. Consider the following two stock portfolios and their respective returns (in per cent) over the last six months.

Both portfolios end up increasing in value from $1,000 to $1,058. However, they clearly differ in volatility. Portfolio A's monthly returns range from -1.5% to 3% whereas Portfolio B's range from -9% to 12%. The standard deviation of the returns is a better measure of volatility than the range because it takes all the values into account. The standard deviation of the six returns for Portfolio A is 1.52; for Portfolio B it is 7.24.

Simple Example of Calculating Standard Deviation Let's say we wanted to calculate the standard deviation for the amounts of gold coins pirates on a pirate ship have. There are 100 pirates on the ship. In statistical terms this means we have a population of 100. If we know the amount of gold coins each of the 100 pirates have, we use the standard deviation equation for an entire population:

What if we don't know the amount of gold coins each of the 100 pirates have? For example, we only had enough time to ask 5 pirates how many gold coins they have. In statistical

terms this means we have a sample size of 5 and in this case we use the standard deviation equation for a sample of a population:

The rest of this example will be done in the case where we have a sample size of 5 pirates, therefore we will be using the standard deviation equation for a sample of a population. Here are the amounts of gold coins the 5 pirates have: 4, 2, 5, 8, 6. Now, let's calculate the standard deviation: 1. Calculate the mean:

2. Calculate

for each value in the sample:

3. Calculate

4. Calculate the standard deviation:

The standard deviation for the amounts of gold coins the pirates have is 2.24 gold coins. Calculate the standard deviation for the following sample data using all methods: 2, 4, 8, 6, 10, and 12. Solution: Method-I: Actual Mean Method

Method-II: Taking Assumed Mean as

Total

How to calculate the standard deviation 1. 2. 3. 4. Compute the square of the difference between each value and the sample mean. Add those values up. Divide the sum by n-1. This is called the variance. Take the square root to obtain the Standard Deviation.

Why n-1?

Why divide by n-1 rather than n in the third step above? In step 1, you compute the difference between each value and the mean of those values. You don't know the true mean of the population; all you know is the mean of your sample. Except for the rare cases where the sample mean happens to equal the population mean, the data will be closer to the sample mean than it will be to the true population mean. So the value you compute in step 2 will probably be a bit smaller (and can't be larger) than what it would be if you used the true population mean in step 1. To make up for this, divide by n-1 rather than n.

But why n-1? If you knew the sample mean, and all but one of the values, you could calculate what that last value must be. Statisticians say there are n-1 degrees of freedom.

When should the SD be computed with a denominator of n?

Statistics books often show two equations to compute the SD, one using n, and the other using n1, in the denominator. Some calculators have two buttons.

The n-1 equation is used in the common situation where you are analyzing a sample of data and wish to make more general conclusions. The SD computed this way (with n-1 in the denominator) is your best guess for the value of the SD in the overall population.

If you simply want to quantify the variation in a particular set of data, and don't plan to extrapolate to make wider conclusions, then you can compute the SD using n in the denominator. The resulting SD is the SD of those particular values. It makes no sense to compute the SD this way if you want to estimate the SD of the population from which those points were drawn. It only makes sense to use n in the denominator when there is no sampling from a population, there is no desire to make general conclusions.

The goal of science is always to generalize, so the equation with n in the denominator should not be used. The only example I can think of where it might make sense is in quantifying the variation among exam scores. But much better would be to show a scatterplot of every score, or a frequency distribution histogram.

Why there is a Minus One in Standard Deviations Introduction Standard deviations are so often calculated when averaging data that functions for them have been standard features of scientific calculators for years but there are, confusingly, a choice of 2 to use. On the calculator buttons, these are typically labelled " n" and " n-1" [for those of you without Greek fonts, that's "sigma subscript n" & "sigma subscript n-1"]. Looking in the manual does not help much, probably just telling you that they are called "population standard deviation" & "sample standard deviation". Even if it gives you the formulae then that only tells you that the former is the root mean square difference of the individual data from the mean of the data whereas the latter is the same thing except that, instead of dividing by n to get the root mean square, n-1 is used. So which should one use & why? Which to use The first question is easier to answer. If you know the mean value of the data from somewhere else, use the n version but if you are calculating the mean value of the data from the data itself (by summing the data & dividing by n or using the button on the calculator) use the n1 version. Normally with a calculator you will be finding averages and standard deviations from a set of measurements so the n-1 one is the one to use. Frankly, if you have lots of data (e.g. 10 more values) and are using standard deviations for their normal use of "standard error" reporting then use just either because the difference between them is negligible compared to other inaccuracies in calculating standard error values. Okay, so that is which one to use but why?

Quick Explanation When the mean is calculated from the n data, there are only n-1 degrees of freedom left to calculate the spread of the data. It would be cheating to use the other degree of freedom again. Essentially, the mean used is not the real mean but a estimate of the mean based on samples of data found in the experiment. This estimate is, of course, biased towards fitting the found data because that is how you got it. Therefore estimating how widely spread around the real mean the data samples are by calculating how spread around the estimated mean they are is going to give a value biased slightly too low. Using n-1 instead of n compensates. Longer Explanation For this, one has to go back two levels; back beyond the use of standard deviation and the derivation of the formulae and think why it is used at all. As with all applied mathematics, there is nothing intrinsically magical about the definitions. They are simply chosen because they are useful. Neither standard deviations as error estimations nor means as averages are the only options available for their tasks. However their combination of ease of calculation, ease of algebraic manipulation & easily understandable connection to reality makes them so popular & ubiquitous that many users do not realise there are alternatives. People want to predict things. That is what all science, engineering & indeed any human thought & intention is all for. People want. They want things to happen, want states of mind, want to know, even sometimes want not want. To get what they want they need to perform actions (even if those actions are purely mental as in some spiritual philosophies or the results are expected away from the physical universe as in some religious philosophies). But what action to perform? There are many to choose from. This choice needs prediction. If one can predict the probable outcome of actions then one has a basis for choosing between actions to get what one wants. The normal way of prediction is looking for rules that have applied well in the past and assuming they will work into the future. It is true that standard proof of such a method, that it has worked well in the past, is circular but at least it is not self-contradictory. It also has the advantage of simplicity (which, whilst maximal simplicity may be difficult to prove as fundamental requirement of theories, is obviously useful if one is to make use of the resulting theories). Unlike its only common rival as a basis for choosing actions, "gut feeling", it has the ability to make unambiguous predictions and can be systematically refined as needed. At this point is tempting to go into a discussion of the overlap of the two whereby the past-rules method uses gut-feeling for generating a priori probabilities for hypotheses and the gut-feeling method is largely past-rule based anyway because brains are naturally brilliant for finding & acting on correlations in past data but I am probably losing some engineer readers with this metaphysics so I will get back to the maths & loose the social scientists! Anyway; science is just the systematic refinement of the process of finding rules from past data to predict the future to decide on actions so that people get what they want. Finding those rules needs many tools and one of those tools is the maths of statistics of which averaging is probably the most common action and estimating uncertainties not far behind.

There is a big intrinsic problem here - we are trying to find general rules but we only have specific examples, the data from our measurements - lets start with a simpler case by pretending we already have access to the rule. In this case the rule is that there are a distribution of possible values that can come out of a measurement with a probability of getting each one. The full rule, a function relating each value to the probability of getting it, is too much hassle for us so we will simplify it to a rule with just two parameters: an indication of the most likely value (the average) & an indication of how far one can expect values typically spread from the most likely value (the deviation). Yes, this is losing a huge amount of detail but if one wants to quantify it with more than two parameters one can; I am sticking with two here because this essay is about standard deviation and two parameters is the simplest case to show it in. There are many options for both the average & and the deviation. The commonest ones are the 'mean' (add up all the possible values weighted by probability) for the average & the 'standard deviation' (add up the squares of all the possible differences from the mean weighted by probability then square root) because they work well (i.e. usefully) in most situations and are mathematically easy. By mathematically easy, I do not necessarily mean that they are easy to calculate. Alternative averages called the 'mode' (the value with highest probability) & 'median' (the value in the middle of the probability distribution) are easier to calculated in some cases as can be taking the average unsigned value of the difference instead of squaring & square rooting for the deviation. Instead I mean that algebra for manipulating the formulae is easier. This enables there to be lots of extra tricks, uses, features etc. if one uses the mean & standard deviation. Typically for algebra, in contrast to computer computer calculations, things work easier if there are no sudden cut-offs or changes in the action of the formulae. For example the sharp change of negating all the negative differences but not the positive differences in the alternative deviation measure above actually makes algebra for manipulating the formula much more messy than the smooth squaring-square-rooting method of removing the signs in the standard deviation. A example of the utility in the most common probability distribution, the 'Gaussian' or 'Normal' distribution. The Gaussian distribution is so common because it is the only distribution shape that stays the same, just rescaling, when convoluted with itself and therefore if the resulting distribution from the combined effect of many independent distributions from different factors is going to tend to anything it will tend to Gaussian. A Gaussian distribution can be completely specified by just its mean & standard distribution. A commonly used corollary of this is that, for a Gaussian distribution, there is a 2/3 approximate probability of getting a value within 1 standard deviation of the mean, 19/20 within 2 & 399/400 within 3. It is not magical that it works so nicely. It is the result of sticking to easy maths so that there are plenty of opportunities for routes to coincide so usefully. Indeed the link to Gaussian is so useful that people often forget that its results don't always apply and use them as unthinkingly as they do means & standard deviations. For example many biological scientists aim to get their experiments to give results with >95% confidence limits and psychological researchers need to confirm their findings on at least 20 people to satisfy journal referees for publication without realising, or caring, that the standards they work almost religiously to were really just the 2

standard deviation positions on Gaussian distributions chosen for convenience in the days before electronic calculators and arbitrarily apply them to distributions that are obviously not Gaussian. So we now have the mean & standard deviation as simple useful measures of the distribution. Now to remove the assumption of a known distribution. From measurements we don't have the distribution, only n values sampled randomly from in the distribution. With these data we can certainly use the same formulae to calculate a mean & standard deviation for the data but what is usually really required is the mean & standard deviation for the distribution in the underlying rule. This subtly is normally ignored. Actually, one cannot literally get the required values but one can estimate them from the data. To generate formulae for these estimations needs some moderately involved algebra but it is simple to get an idea of what they should be. As more & more data is collected, it will become more & more unlikely that the distribution of data values will tend to anything other than a duplicate of the probability distribution of the underlying rule. Therefore, for sufficiently large data sets, one can simply use the mean & standard deviation calculated from the data as estimates of the mean & standard deviation of the underlying rule. That is the same result as if one had sloppily ignored the distinction between the measurements & the hidden rule in the first place. What if one has less data and so needs the full versions of the formulae not the limiting cases? I am not going type a load of maths here in HTML (see a maths textbook like Matthews & Walker for the details) but here is an outline of the argument for the simple Gaussian case. Start by calculating the probability of getting a particular measurement value leaving everything as algebraic variables so one has an equation in terms of the value, the rule mean & rule standard deviation. This will be of the form of a constant raised to the negative power of the square of the ratio of the difference of the value from the mean to the standard deviation for a Gaussian. Now work out the probability of getting a whole set of n data values by multiplying n such terms together. The most probable values of the mean & standard deviation can then be found by maximising the probability as a function of the n values. (Pedantic note: Philosophers may object to me casually switching the direction of the probability calculation here because I am implicitly assuming equal a priori probabilities for the possible mean & standard deviation values but some hypothesis is needed & this is the simplest.) The maximisation is eased by grouping all the exponents into one then taking logs so the only thing left to maximise is polynomial of order 2 which is trivially handled by differential calculus. The result, once rearranged, are formulae for the most likely rule mean & standard deviation. The mean one is identical to that for the data & the standard deviation is almost the same as the one for the data except that the dominator in the averaging is not n but n-1. The distribution in the hidden underlying rule is conventionally called the "population" & the collected data the "sample" so the two formulae for the standard distribution are called the "population standard distribution" & the "sample standard distribution" respectively. Addendum: Divide by Square Root of n? Whilst I am at it, there is another related thing that causes great confusion. Does one divide the standard deviation by the square root of n or not? Sometimes one sees this done and sometimes not. Which is correct depends on to what the the standard deviation applies. It is a

point that is often ignored but standard deviations can be used for several purposes & there is a third common one in addition to the two above. The two above were both the standard deviations of values, whether recorded data or probabilities in the underlying rule, about the mean. The third one is the "standard deviation of the mean" and is a measure not of who the values are distributed about a mean but how one mean, the one from the data, is distributed about another, the hidden one in the rule. Of course, it is rather meaningless to ask for the distribution of a single item but if one did the test multiple times then one would get slightly different values for the mean of data each time and each can be treated as an estimate for the mean in the underlying rule with a random inaccuracy in each. It is actually possible to estimate that standard deviation without having to collect multiple data sets by simply dividing the sample standard deviation by the square root of n. This also resolves the problem with the intuitive feeling the inaccuracy represented by the standard deviation should decrease as one gets more data but that the standard distribution, being the width of the underlying distribution, should be a constant. Both are correct because those are standard distributions of two different things that just happen to be calculated from the same data and usually sloppily given the same name. One can derive the formulae by churning through the same maths as before but doing it for probability of getting a mean of a sample of the distribution being a certain value this time (yes, it is messier maths) & out pops the answer that the probability of the mean also forms a Gaussian & its standard deviation is the same formula as before but with that extra division by n factor. Whereas the difference between the other two standard distributions is normally negligible, this one normally much smaller than the other two so you do have to remember if you are using the standard deviation of the mean or not.

Coefficient of Variation The coefficient of variation measures variability in relation to the mean (or average) and is used to compare the relative dispersion in one type of data with the relative dispersion in another type of data. The data to be compared may be in the same units, in different units, with the same mean, or with different means. It is a statistical measure of the dispersion of data points in a data series around the mean. It is calculated as follows:

The coefficient of variation is useful because the standard deviation of data must always be understood in the context of the mean of the data. The coefficient of variation is a dimensionless

number. So for comparison between data sets with different units or widely different means, one should use the coefficient of variation instead of the standard deviation. Coefficient of variation is used to know the consistency of the data. By consistency we mean the uniformity in the values of the data/distribution from arithmetic mean of the data/distribution. A distribution with smaller coefficient of variation than the other is taken as more consistent than the other.

In the investing world, the coefficient of variation allows you to determine how much volatility (risk) you are assuming in comparison to the amount of return you can expect from your investment. In simple language, the lower the ratio of standard deviation to mean return, the better your risk-return tradeoff.