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440: Lecture 32
Strong law of large numbers and Jensen’s
inequality
Scott Sheffield
MIT
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18.440 Lecture 32
Outline
Jensen’s inequality
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18.440 Lecture 32
Outline
Jensen’s inequality
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18.440 Lecture 32
Pedro’s hopes and dreams
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18.440 Lecture 32
Pedro’s hopes and dreams
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18.440 Lecture 32
Pedro’s financial planning
I How would you advise Pedro to invest over the next 10 years
if Pedro wants to be completely sure that he doesn’t lose
money?
I What if Pedro is willing to accept substantial risk if it means
there is a good chance it will enable his grandchildren to retire
in comfort 100 years from now?
I What if Pedro wants the money for himself in ten years?
I Let’s do some simulations.
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18.440 Lecture 32
Logarithmic point of view
I We wrote Tn = R1 × . . . × Rn . P
Taking logs, we can write
Xi = log Ri and Sn = log Tn = ni=1 Xi .
I Now Sn is a sum of i.i.d. random variables.
I E [X1 ] = E [log R1 ] = .53(log 1.15) + .47(log .85) ≈ −.0023.
I By the law of large numbers, if we take n extremely large,
then Sn /n ≈ −.0023 with high probability.
I This means that, when n is large, Sn is usually a very negative
value, which means Tn is usually very close to zero (even
though its expectation is very large).
I Bad news for Pedro’s grandchildren. After 100 years, the
portfolio is probably in bad shape. But what if Pedro takes an
even longer view? Will Tn converge to zero with probability
one as n gets large? Or will Tn perhaps always eventually
rebound?
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18.440 Lecture 32
Outline
Jensen’s inequality
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18.440 Lecture 32
Outline
Jensen’s inequality
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18.440 Lecture 32
Strong law of large numbers
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18.440 Lecture 32
Strong law implies weak law
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18.440 Lecture 32
Proof of strong law assuming E [X 4 ] < ∞
I Assume K := E [X 4 ] < ∞. Not necessary, but simplifies proof.
I Note: Var[X 2 ] = E [X 4 ] − E [X 2 ]2 > 0, so E [X 2 ]2 ≤ K .
I The strong law holds for i.i.d. copies of X if and only if it
holds for i.i.d. copies of X − µ where µ is a constant.
I So we may as well assume E [X ] = 0.
I Key to proof is to bound fourth moments of An .
I E [A4n ] = n−4 E [Sn4 ] = n−4 E [(X1 + X2 + . . . + Xn )4 ].
I Expand (X1 + . . . + Xn )4 . Five kinds of terms: Xi Xj Xk Xl and
Xi Xj Xk2 and Xi Xj3 and Xi2 Xj2 and Xi4 .
The first three terms all have expectation zero. There are n2
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of the fourth type and n of the last type, each equal to at
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most K . So E [An ] ≤ n −4 6 n2 + n K .
Thus E [ ∞
P 4
P∞ 4
P∞ 4
n=1 An ] = n=1 E [An ] < ∞. So n=1 An < ∞
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(and hence An → 0) with probability 1.
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18.440 Lecture 32
Outline
Jensen’s inequality
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18.440 Lecture 32
Outline
Jensen’s inequality
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18.440 Lecture 32
Jensen’s inequality statement
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18.440 Lecture 32
More about Pedro
I Disappointed by the strong law of large numbers, Pedro seeks
a better way to make money.
I Signs up for job as “hedge fund manager”. Allows him to
manage C ≈ 109 dollars of somebody else’s money. At end of
each year, he and his staff get two percent of principle plus
twenty percent of profit.
I Precisely: if X is end-of-year portfolio value, Pedro gets
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18.440 Lecture 32
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