We introduced Regression Analysis last month in order to understand whether Apple’s earnings announcements were significant or not (see “Was Apple’s Earnings Announcement Really Important?”).

What we did not do was go in-depth into just what information regression analysis produces. Since this statistical technique is often used, it might be helpful to explore the output produced.

With this greater understanding we can make more informed decisions and ask better questions about the data we are looking at, and ultimately determine whether or not regression analysis is in fact the correct tool to use.

**The Basic Output**

Figure A is a screenshot of regression output from the R statistical program.

This output has been divided into sections that we will reference throughout the post. The regression results in Figure A come from a data set in the book

Figure A

Regression Output From R

*Statistical Methods, 8 ed.*by Snedecor and Cochran (one of my favorites). The data is included in the graphic below the output (xvar and yvar).**The Estimates**

The estimates of the regression equation are shown in the A box in Figure A. The regression equation (like any mathematical equation of a line shown in this form) is composed of two terms – the

*intercept*and the*slope*. In Figure A the intercept is 64.2468 and the slope is -1.0130.
Figure B contains the set of equations that are involved in arriving at these values. Working from the bottom up, equations 6 and 7 are simply the averages of the X and Y data sets. The Y term,

which is on the other side of the “=” sign in equation 1, is the

Figure B

Regression Estimate Equations

*dependent variable*and the X term is the*independent variable*. The bar symbol is used to depict averages, and the result is then often referred to as “X bar” or “Y bar”.
Once we have averages, we can calculate how much each individual data point varies from its average, which is shown in equations 4 and 5. For example, the 3

^{rd}X data point is 11, so in our equation notation we would say X_{3}= 11. The average of all X’s is 19, so X bar = 19, and thus the difference is 8, so x_{3}= 8 (note the upper case letters refer to the raw data and the lower case letters refer to the difference between the raw data and its average).
With these values we can calculate the slope estimate (b

_{1}) with equation 3, and the intercept estimate (b_{0}) with equation 2.
The final regression equation is equation 1. The slope multiplies, or

*scales*, the X_{i}data point, to which we then add the intercept, to come up with an estimate of the dependent variable for that data point. Using the 3^{rd}one again, we come up with a Y value of 53.1039 (64.2468 - 1.0130 * 11). The symbol on top of the Y in equation 1 is called a “hat”, and thus it is the case that the estimated Y value is referred to as “Y hat”. Note that this is not the actual value of Y_{i}(without the hat!). We’ll explore this soon.**Diving Into the Beta Estimate**

In the B box of Figure A we are shown additional statistics for the b

shown in Figure C.

_{1}estimate, often referred to as the*Beta*estimate (for lovers of Greek letters!). The equations that calculate these values are
Figure C

Beta Estimate Equations

Starting from near the bottom, equation 5, in the upper term, calculates the difference between the

*actual*Y values and the*fitted*Y values (i.e. “Y hat” values). This difference is called the*residual*. The residuals are then squared and divided by the number of data points in the data set less 2. Finally, each individual calculation is added up to arrive at a total. This is the standard equation for*variance*.
Equation 4 takes the variance of the residuals that was just calculated and divides this by the sum of the variances of the x term only. This value is the variance of the b

_{1}term, and equation 3 then takes the square root of this number. The result of equation 3 is shown in Figure A under the “Std. Error” column.
We can think about the math involved in this equation in order to understand the Beta estimate a little better. The standard error of the b

_{1}term is 0.1722 (from Figure A). Now if the variance of x got smaller and smaller, so as to approach 0, then the standard error would become larger and larger (think 10/5 is 2, 10/4 is 2.5, etc.). If X hardly varies at all, while Y varies a great deal more, then the value of X as a predictor becomes more negligible. Because of this, we cannot have as much “confidence” that the b_{1}value provided is the “real” b_{1}value. For this reason, we must apply a larger margin of error for that term to grant more leeway for what the value might be.
Fortunately for us, Equation 2 helps us get to the same place. The t-value numerator is the difference between the estimate of the factor (b

_{1}) and the hypothesis that the factor does not matter (the “null” hypothesis: β_{1}=0). The difference between these two numbers is then divided by the standard error of b_{1}(in effect scaling the difference). In our Figure A example the t-value of the b_{1}estimate is -5.884.
The t-value is then analyzed using a statistical distribution known as Student’s t. The inputs for this analysis are the t-statistic calculated above and the “degrees of freedom” used in the estimation process.

With the t-distribution we can do 2 things. First, we can calculate the probability that the t-value for the Beta estimate would occur even if the null hypothesis were in fact true (i.e. the “real” value of b

_{1}was 0). This is known as the*p-value*and is the value in last column of the B box of Figure A. Accordingly, we interpret this value as follows:
“The probability that we would calculate a beta estimate of -1.013 when the true value was 0 is 0.0154%”

This is a pretty low chance, so we are likely to conclude that the beta estimate from this regression equation matters.

The

other thing we can do with the t-value is calculate the

Figure D

Beta Confidence Limits

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*confidence limits*of our b_{1}estimate. If we choose to say we want to be 95% confident of the estimate (a common threshold in statistics), we can convert this into the required t-value. We then take this t-value amount and multiply it by equation 3, and then both add and subtract this from our b_{1}estimate as shown in equation 1. Figure D shows the confidence levels for our equation calculated in Excel as -0.629 and -1.397. This means that even if b_{1}is not__precisely__-1.013 we can be pretty certain it lies somewhere in this range.**Diving Into the Alpha Estimate**

In the C box of Figure A we are shown additional statistics for the b

in Figure E (note that some of the inputs are from the prior Beta set of equations).

_{0}estimate, often referred to as the*Alpha*estimate (again, for lovers of Greek letters). The equations used for this are shown
Figure E

Alpha Estimate Equations

Equation 3 shows that the variance of the b

_{0}estimate is equal to the variance of the b_{1}estimate multiplied by the sum of all the independent variables squared, with the resulting calculation divided by the number of items in the data set. The square root of this value is then taken in equation 2, with the resulting figure in the first column of the C box in Figure A.
Equation 1 calculates the t-value for the alpha estimate using the null hypothesis (i.e. β

we did in the prior section, we can a) calculate the probability that the value we arrived at would occur if the true value were 0, and b) the confidence limits of the Alpha estimate (shown in Excel format in Figure F).

_{0}=0). With the t-value, in the same way
Figure F

Alpha Confidence Limits

**The Analysis of Variance**

In the D box of Figure A we are shown what is called an “Analysis of Variance Table”. This table divides up the regression results into those that can be attributed to the

Beta estimate and what remains for the residuals.

Figure G

ANOVA Equations

The equations involved in calculating this table are show in Figure G.

Equation 8 calculates the

*variance*of the dependent variable data set by taking each result from equation 5 in Figure B, squaring it, and then adding all of these up. This total is then divided by the total number of data elements less 1.
Equation 7 calculates the sum total of the squared deviations in the Y data set (it is essentially the top half of Equation 8), while equation 6 calculates the sum total of the squared deviations of the Y residuals. The only difference between these two calculations is whether or not Y has a “hat” or a “bar”.

The numerator of equation 6 multiples the difference in each X from its mean by the difference in each Y from its mean, and then squares the result. The denominator squares each X’s difference from its mean.

The “Sum Sq.” column is additive, meaning if we take the results of equation 6 and 7 and add them together we get equation 8, which provides a nice way to check our work.

Equations 2, 3 and 4 are used to populate the “Mean Sq.” column. Each one of these equations has been discussed previously in this post. In addition, however, for the regression and residual items, each of these can also be calculated by taking the results in the “Sum Sq.” column and dividing by the number of degrees of freedom, again providing a check against our prior work up to this point.

Equation 1 calculates the F-statistic for the regression, which is the ratio of variance “explained” by our regression equation to the variance “left over” after this explanation. This statistic is then analyzed using the F-distribution. Similar to the t-distribution discussed in the Beta estimate section, we can then use this comparison to calculate the probability that the variance ratio of our regression would occur simply by chance assuming there was no statistical relationship.

**Other Summary Results**

The E box of Figure A shows a variety of data from the regression, and most of the elements in this box are items we have already seen.

The “Residual Standard Error” is simply the square root of equation 3 in Figure G. The F statistic data is the same as discussed in the last section.

The only new terms in this section are the r-squared and adjusted r-squared items. The equations

for these are shown in Figure H. The inputs into these equations come from those in Figure G (equations 6 and 7) with the exception of the degrees of freedom.

Figure H

Other Output Equations

If you follow the Wikipedia link you will see that degrees of freedom is a complex mathematical concept. For our purposes we will say that a degree of freedom is “used” to create a variable. For example, if we have 5 numbers and calculate an average, we use one degree of freedom, so there are 4 degrees of freedom remaining in the data set.

For a simple linear regression 2 degrees of freedom are used. For this reason, the degrees of freedom is the number of elements in

the data set minus 2.

Figure I

Density Curve Comparison

**Diving Into the Residuals**

The residuals from a regression equation should be distributed normally with a mean of 0 and a standard deviation given by the standard error (the square root of Figure G’s equation 8).

The F box of Figure A shows a summary of the quartile distribution of the residuals. Since the mean of the residuals should be 0, the median of this value should also be close to 0. In our case we observe that the median data point is -0.1169, which

is not too terribly different from 0 given that we only have 12 residuals to calculate the data from.

Figure J

Residual Plot: From Regression

Figure I compares the probability density curve of the actual data to that of a random sample of data taken from a normal distribution with a mean of 0 and a standard deviation equal to that of the regression. Visually examining these lines shows us that the fit is fairly good.

A common means of visually testing normality is by observing the plot of residuals, which is shown in Figure J. Under a normal set of conditions, each quadrant in the graph should look similar to all the others from two perspectives – the number of data points and the number of extreme values.

In our

case, the upper left and lower right quadrants contain more data points than the other 2, which might indicate a non-normal distribution to the residuals. In addition, the more extreme value points are also contained in those quadrants.

Figure K

Residual Plot: Normal Example

For comparison, Figure K is a graph of 1,000 randomly generated data points with a mean of 0 and a standard deviation of 1. As you can see, upon visual inspection no quadrant appears to be unduly heavy or light with data points. In addition, extreme values exist in all the quadrants as well.

Finally, a QQ plot compares the residuals to known theoretical distribution. Figure L plots the residuals from our regression in orange, and compares that to a normal distribution with a mean of 0 and a standard deviation equal to 5.233 (the standard error as discussed above and shown in the E box of Figure A). The residuals should lie close to the line in order to be a good fit.

For

some examples of what QQ plots look like when things are not normal go to the Murdoch University website (where they make the claim “A sufficiently trained statistician can read the vagaries of a Q-Q plot like a shaman can read a chicken's entrails”!).

Figure L

QQ Plot

There are equation forms of testing as well, called “Goodness of Fit” tests, which we will save for later.

**Questions to Ask**

In many cases we are in the role of consuming regression data rather than creating it. Some examples might be when we are: a) members of a project selection or steering committee where several groups are attempting to “pitch” their solutions, or b) meeting with bankers or consultants with products/services to sell, or c) supervising individuals/groups who are performing the actual analytical work.

In these situations we are in a position where we do not know as much as those we are communicating with, which can make it difficult to ascertain whether the decisions we might be led to make are based on good information or not.

Some questions that will help us “get comfort” with the analysis are:

**1. What Evaluations Did You Perform With the Residuals and What Were the Results?**

For linear regression, residuals need to be normal in order for us to use t-tests of significance, confidence levels, r-squares and probability estimates among other things. These estimators and tests are incorrect if the residuals are not normal.

Non-normal distributions might be due to too little data. Other times it might mean there is an underlying data structure that requires different tools to assess. We might be omitting significant independent variables that play a critical

role in determining what the Y values should be.

Figure M

Linear vs. Quadratic Comparison

Figure M shows regression results for 2 data sets, both driven by the same variable. As you may notice, while the QQ plots may look fairly good, the residual plots clearly show that the right hand data set has some curvature to it. If we used the left hand equation to make future estimates, we would under-predict the extremes and over-predict the middles on a consistent basis.

A puzzled look when asked this question, or a mention of some other factor like “the r-squares were so high”, or hemming and hawing all indicate that testing the normality assumption was not sufficiently performed.

Folks who have tested for normality should be able to produce or discuss the various plots talked about above and what they indicated, and other goodness of fit testing that was conducted as well.

**2. How Were Outliers Handled and Why?**

Another reason to examine residuals is to identify potential problems with our data. Sometimes one or two points will “stick out like a sore thumb”. These require further investigation.

Perhaps there was a data entry error such as a transposition of two numbers or the omission of a decimal point. Perhaps there was a one-time unusual event. If we are regressing earnings numbers sometimes we pick up those special charges that we did not intend to.

However, in pursuit of getting “better” regression results, we may sometimes label something an “outlier” and on that basis omit it from the data set used to create

the regression results. This is dangerous if the data truly should be concluded.

Figure N

Outlier Impacts

This spreadsheet is available for download! And it contains all the equations covered in this post. Visit my Online Red Kettle for details. Hurry, it ends January 31st.

Figure N shows the “before and after” once the 3

^{rd}set of data elements from the Figure A regression is eliminated. All the statistics improve – t-values are higher, the residual error is less, the r-squared values are higher. Yet, without a compelling reason to do so, simply eliminating data to make the regression stats better is not a very good analysis.
Asking this question should surface if any outliers were eliminated and the reasoning behind them, allowing you to also participate in evaluating whether an outlier truly is just such a thing. One must do this with caution – just because something is a rare occurrence, such as a stock market bubble or crash, doesn’t mean they are an outlier. As history has shown, bubbles and crashes are in fact repeating events.

**3. Why Are the Variables Selected Appropriate?**

Because we use terms such as independent and dependent variable, and we make statements about the results such as the “change in this value is associated with a change in that value”, and there is an underlying human tendency to create cause and effect explanations even when there are not any, we can be vulnerable to associating meaning to the analysis when we should not.

There is an old saying in analysis that “correlation is not causation”. For example, let’s consider having a cough and a stuffy nose. If we regress one of these factors on another we will likely get very good regression statistics. Yet, did our cough cause our stuffy nose? Did our stuffy nose cause our cough? In all likelihood the

cause is a variable not part of our analysis – a cold or flu virus!

Figure O

What Causes What?

This spreadsheet is available for download! And it contains all the equations covered in this post. Visit my Online Red Kettle for details. Hurry, it ends January 31st.

Figure O shows the results of our original Figure A regression compared to the results when the data is “flipped” – in other words what used to be X is now Y, and what is Y is now X. The values for the estimates are slightly different, but the r-squared and F statistics are exactly the same and indicate high probability.

So, does X cause Y, or does Y cause X? Both are plausible solutions. Determining the circumstances under which we can determine causation is a qualitative judgment, and likely one that should be reviewed.

**4. Are Variables Measuring What We Want Them To?**

Given that access to data is sometimes difficult, there is a temptation to use the data that is provided. However, depending on what we hope to learn from our analysis it might not be in the best format…or it might not be appropriate at all!

There are times when we want to understand the changes in things. For example, we need to construct a hedge ratio for a particular risk we wish to mitigate. In this case it is the changes that we need to protect against. If corn is $2 or if it is $6, if it moves by 30 cents I want my hedge instrument to move in likewise fashion.

So to examine how this can impact things, I took the original data set and converted it to percentage changes. This means that if the original set had X at 25 and Y at 40, and the next X value was at 30 and the next Y value at 42, then the transformed

This spreadsheet is available for download! And it contains all the equations covered in this post. Visit my Online Red Kettle for details. Hurry, it ends January 31st.
data set would be X = 20% ((30-25)/25) and Y= 5% ((42-40)/40).

Figure P

Datatype Impact

Figure P shows how this change in data dramatically impacts our results. From a relatively high r-square in the 70’s we go to one close to 0, essentially no relationship between the movement of X and the movement of Y!

And all due to simply transforming the existing data.

**Key Takeaways**

**Regression analysis is comprised of a series of equation and assumptions. It can be used to generate extremely useful and valuable insights, but those who are going to rely on this output to support important decisions need to dig into the results in order to determine whether the analysis is in fact reliable or not.**

**Questions**

· What questions would you recommend someone ask when presented with the output of a regression analysis?

*Add to the discussion**with your thoughts, comments, questions and feedback!*

**Please share Treasury Café with others**. Thank you!
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