RegressIt: free Excel add-in for linear regression and multivariate data analysis

After fitting a number of different statistical forecasting models to a given data set, you usually have a wealth of criteria by which they can be compared:

**Error measures in the estimation period:**mean*squared*error, mean*absolute*error, mean absolute*percentage*error,*mean*error, mean*percentage*error**Error measures in the validation period:**Ditto**Residual diagnostics and goodness-of-fit tests:**plots of residuals versus time, versus predicted values, and versus other variables; residual autocorrelation plots, crosscorrelation plots, and normal probability plots; the Durbin-Watson statistic (another indicator of serial correlation); coefficients of skewness and kurtosis (other indicators of non-normality); measures of extreme or influential observations; tests for excessive runs, changes in mean, or changes in variance (lots of things that can be "OK" or "not OK")**Qualitative considerations:**appearance of forecast plots, intuitive reasonableness of the model, simplicity of the model

With so many plots and statistics and considerations to worry about, it's sometimes hard to know which comparisons are most important. What's the real bottom line?

If there is any one statistic
that normally takes precedence over
the others, it is the **mean squared error within the estimation
period**, or equivalently its square root, the **root mean squared
error**. The latter quantity
is also known as the **standard error of the estimate** in
regression analysis or the **estimated white noise standard deviation**
in ARIMA analysis. This is the statistic whose value is minimized
during the parameter estimation process, and it is the statistic
that determines the width of the confidence intervals for predictions.
The 95% confidence intervals for one-step-ahead forecasts are
approximately equal to the point forecast "plus or minus
2 standard errors"--i.e., plus or minus 2 times the root-mean-squared
error.

Having planted this stake in the ground, there are several observations and qualifications that need to be made:

- For purposes of communicating your results
to others, it is
usually best to report the
**root**mean squared error (RMSE) rather than mean squared error (MSE), because the RMSE is measured in the*same units as the data*, rather than in squared units, and is representative of the size of a "typical" error. - The mean absolute error (MAE) is also measured in the same units as the original data, and is usually similar in magnitude to, but slightly smaller than, the root mean squared error. The mathematically challenged usually find this an easier statistic to understand than the RMSE.
- The mean absolute
*percentage*error (MAPE) is also often useful for purposes of reporting, because it is expressed in generic percentage terms which will make some kind of sense even to someone who has no idea what constitutes a "big" error in terms of dollars spent or widgets sold. The MAPE can only be computed with respect to data that are guaranteed to be strictly positive. (Note: if the Statgraphics Forecasting procedure does not display MAPE in its model-fitting results, this usually means that the input variable contains zeroes or negative numbers, which can happen if it was differenced outside the forecasting procedure or if it represents a quantity that can honestly be zero in some periods. The latter situation may arise when dealing with highly disaggregated data--e.g., sales of a particular color of a particular model by a particular store.) - The
*mean error*(ME) and mean percentage error (MPE) that are reported in some statistical procedures are*signed*measures of error which indicate whether the forecasts are*biased*--i.e., whether they tend to be disproportionately positive or negative. Bias is normally considered a bad thing, but it is not the bottom line. Bias is one component of the mean squared error--in fact*mean squared error equals the variance of the errors plus the square of the mean error.*That is:**MSE = VAR(E) + (ME)^2**. (This formula is useful when you need to compute MSE in a spreadsheet model, as we did in the Outboard Marine spreadsheet.) Hence, if you try to minimize mean squared error, you are implicitly minimizing the bias as well as the variance of the errors. In a model that includes a*constant*term, the mean squared error will be minimized when the mean error is*exactly zero*, so you should expect the mean error to always be zero within the estimation period in a model that includes a constant term. (Note: as reported in the Statgraphics Forecasting procedure, the mean error in the estimation period may be slightly different from zero if the model included a log transformation as an option, because the forecasts and errors are automatically unlogged before the statistics are computed--see below.) - The root mean squared error is more sensitive than other
measures
to the
*occasional large error*: the squaring process gives disproportionate weight to very large errors. If an occasional large error is not a problem in your decision situation (e.g., if the true cost of an error is roughly proportional to the size of the error, not the square of the error), then the MAE or MAPE may be a more relevant criterion. In many cases these statistics will vary in unison--the model that is best on one of them will also be better on the others--but this may not be the case when the error distribution has "outliers." (Actually, if one model is best on one measure and another is best on another measure, they are probably pretty similar in terms of their average errors. In such cases you probably should give more weight to some of the other criteria for comparing models--e.g., simplicity, intuitive reasonableness, etc.) - The root mean squared error (and mean absolute error) can
only
be compared between models whose errors are measured in the
*same units*(e.g., dollars, or constant dollars, or widgets sold, or whatever). If one model's errors are adjusted for inflation while those of another or not, or if one model's errors are in absolute units while another's are in logged units, their error measures cannot be directly compared. In such cases, you have to convert the errors of both models into comparable units before computing the various measures. This means converting the forecasts of one model to the same units as those of the other by unlogging or undeflating (or whatever), then subtracting those forecasts from actual values to obtain errors in comparable units, then computing statistics of those errors. You*cannot*get the same effect by merely unlogging or undeflating the error statistics themselves! The Forecasting procedure in Statgraphics is designed to take care of these calculations for you: the errors are automatically converted back into the original units of the input variable (i.e., all transformations performed as options within the Forecasting procedure are reversed) before computing the statistics shown in the Analysis Summary report and Model Comparison report. However, other procedures in Statgraphics (and most other stat programs) do not make life this easy for you. - There is no absolute criterion for a "good" value of RMSE or MAE: it depends on the units in which the variable is measured and on the degree of forecasting accuracy, as measured in those units, which is sought in a particular application. Depending on the choice of units, the MRSE or MAE of your best model could be measured in zillions or one-zillionths. It makes no sense to say "the model is good (bad) because the root mean squared error is less (greater) than x", unless you are referring to a specific degree of accuracy that is relevant to your forecasting application.
- When comparing regression models that use the same
dependent
variable and the same estimation period, the
*root-mean-squared-error goes down as adjusted R-squared goes up.*Hence, the model with the highest adjusted R-squared will have the lowest root mean squared error, and you can just as well use adjusted R-squared as a guide. However, when comparing regression models in which the dependent variables were transformed in different ways (e.g., differenced in one case and undifferenced in another, or logged in one case and unlogged in another), or which used different sets of observations as the estimation period, R-squared is not a reliable guide to model quality. (See the notes on "What's a good value for R-squared?") - Don't split hairs: a model with a root-mean-squared error of 3.25 is not really much better than one with an RMSE of 3.32. Remember that the width of the confidence intervals is proportional to the RMSE, and ask yourself how much of a relative decrease in the width of the confidence intervals would be noticeable on a plot. It may be useful to think of this in percentage terms: if one model's RMSE is 30% lower than another's, that is probably very significant. If it is 10% lower, that is probably somewhat significant. If it is only 2% better, that is probably not significant. These distinctions are especially important when you are trading off model complexity against the error measures: it is probably not worth adding another independent variable to a regression model to decrease the RMSE by only a few more percent. (Note: the RMSE and adjusted R-squared statistics already include a minor adjustment for the number of coefficients estimated in order to make them "unbiased estimators", but a heavier penalty on model complexity really ought to be imposed for purposes of selecting among models. Sophisticated software for automatic model selection generally seeks to minimize error measures which impose such a heavier penalty, such as the Mallows Cp statistic, the Akaike Information Criterion (AIC) or Schwarz' Bayesian Information Criterion (BIC). How these are computed is somewhat beyond the scope of the current discussion, but suffice it to say that when you--rather than the computer--are selecting among models, you should show some preference for the model with fewer parameters, other things being approximately equal.)
- The root mean squared error is a valid indicator of
relative model
quality
*only**if it can be trusted*. If there is evidence that the model is badly mis-specified (i.e., if it*grossly*fails the diagnostic tests of its underlying assumptions) or that the data in the estimation period has been*over-fitted*(i.e., if the model has a relatively large number of parameters for the number of observations fitted and its comparative performance deteriorates badly in the validation period), then the root mean squared error*and all other error measures*in the estimation period may need to be heavily discounted. (If there is evidence only of*minor*mis-specification of the model--e.g., modest amounts of autocorrelation in the residuals--this does not completely invalidate the model or its error statistics. Rather, it only suggests that some fine-tuning of the model is still possible. For example, it may indicate that another lagged variable could be profitably added to a regression or ARIMA model.) - The error measures in the
*validation period*are also very important--indeed, in theory the model's performance in the validation period is the best guide to its ability to predict the future. The caveat here is the validation period is usually a much*smaller sample of data*than the estimation period. Hence, it is possible that a model may do unusually well or badly in the validation period merely by virtue of getting lucky or unlucky--e.g., by making the right guess about an unforeseeable upturn or downturn in the near future, or by being less sensitive than other models to an unusual event that happens at the start of the validation period. Unless you have enough data to hold out a large and representative sample for validation, it is probably better to interpret the validation period statistics in a more qualitative way: do they wave a "red flag" concerning the possible unreliability of statistics in the estimation period, or not? (Remember that the comparative error statistics that Statgraphics reports for the estimation and validation periods are in*original, untransformed units*. If you used a log transformation as a model option in order to reduce heteroscedasticity in the residuals, you should expect the unlogged errors in the validation period to be much larger than those in the estimation period. Of course, you can still compare validation-period statistics across models in this case.) - In trying to ascertain whether the error measures in the
estimation
period are reliable, you should consider whether the model under
consideration is
*likely*to have overfitted the data. If the model has only one or two parameters (such as a random walk, exponential smoothing, or simple regression model) and was fitted to a moderate or large sample of data (e.g., 30 observations or more), then it is probably unlikely to have overfitted the data. But if it has many parameters relative to the number of observations in the estimation period (e.g., a model that uses seasonal adjustment and/or a large number of regressors), then overfitting is a distinct possibility. As a rough guide here, calculate the number of data points in the estimation period per coefficient estimated, including seasonal indices if any. If you have much less than*10 data points per coefficient estimated,*you should be alert to the possibility of overfitting, and with less than 5 data points per coefficient there is very real danger. (Think of it this way: how large a sample of data would you want in order to estimate a single coefficient, namely the mean? Although there are efficiencies to be gained when estimating several coefficients simultaneously from the same sample, this is still a useful guide.) For example, I would hesitate to fit a model with as many as 4 regressors to a sample of only 20 data points, and I would be cautious about estimating seasonal indices with less than 4 full seasons of data. Also, regression models which are chosen by applying*automatic model-selection techniques*(e.g., stepwise or all-possible regressions) to*large numbers of potential variables*are prone to overfit the data, even if the number of regressors in the final model is small. Of course, sometimes you have little choice about the number of parameters the model ought to include: for example, if the data are strongly seasonal, then you must estimate the seasonal pattern in some fashion, no matter how small the sample. But in such cases, you should expect the errors made in predicting the future to be larger than those that were made in fitting the past. (Note: ARIMA models appear at first glance to require relatively few parameters to fit seasonal patterns, but this is somewhat misleading. In order to*initialize*a seasonal ARIMA model, it is necessarily to estimate the seasonal pattern that occurred in "year 0," which is comparable to the problem of estimating a full set of seasonal indices. Indeed, it is usually claimed that more seasons of data are required to fit a seasonal ARIMA model than to fit a seasonal decomposition model.) - By the same token, in trying to judge whether the error
statistics
are reliable, you should ask whether it is
*likely*that the model is*mis-specified*. Are its assumptions intuitively reasonable? Would it be easy or hard to explain this model to someone else? Do the forecast plots look like a reasonable extrapolation of the past data? If the assumptions seem reasonable, then it is more likely that the error statistics can be trusted than if the assumptions were questionable. - Although the confidence intervals for one-step-ahead
forecasts
are based almost entirely on RMSE, the confidence intervals for
the longer-horizon forecasts than can be produced by time-series
models depend heavily on the underlying modeling assumptions,
particularly assumptions about the variability of the trend.
The confidence intervals for some models widen relatively slowly
as the forecast horizon is lengthened (e.g., simple exponential
smoothing models with small values of "alpha", simple
moving averages, seasonal random walk models, and linear trend
models). The confidence intervals widen much faster for other
kinds of models (e.g., nonseasonal random walk models, seasonal
random trend models, or linear exponential smoothing models).
The rate at which the confidence intervals widen is not a reliable
guide to model quality: what is important is the model should
be making the
*correct*assumptions about how uncertain the future is. It is very important that the model should pass the various residual diagnostic tests and "eyeball" tests in order for the confidence intervals for longer-horizon forecasts to be taken seriously.

So... the bottom line is that
you should put the most weight on
the **error measures in the estimation period**--most often
the RMSE, but sometimes MAE or MAPE--when comparing among
models. (If your software is capable of computing them, you may also
want to look at Cp, AIC or BIC.) But you should keep an eye on the
validation-period results,
residual diagnostic tests, and qualitative considerations such
as the intuitive reasonableness and simplicity of your model. The
residual diagnostic tests are not the bottom line--you should
never choose Model A over Model B merely because model B got more
"OK's" on its residual tests. (What would you rather
have: smaller errors or more random-looking errors?) A model which
fails some of the residual tests or reality checks in only a *minor*
way is probably subject to further improvement,
whereas it is the model which flunks such tests in a *major* way
that cannot be trusted.

The validation-period
results are not necessarily the last word either, because of the issue
of sample size: if Model A
is slightly better in a validation period of size 10 while Model
B is *much* better over an estimation period of size 40,
I would study the data closely to try to ascertain whether Model A
merely "got lucky"
in the validation period.

Finally, remember to **K.I.S.S.**
(keep it simple...) If two models are generally similar in terms of
their error statistics and other diagnostics, you should prefer the one
that is simpler and/or easier to understand. The simpler model is
likely to be closer to the truth, and it will usually be more easily
accepted by others.

RegressIt: free Excel add-in for linear regression and multivariate data analysis