Notes
on linear regression analysis (pdf)

Introduction to
linear regression analysis

Mathematics
of simple regression

Regression examples

·
Beer sales vs. price, part 1: descriptive
analysis

·
Beer sales vs. price, part 2: fitting a simple
model

·
Beer sales vs. price, part 3: transformations
of variables

·
Beer sales vs.
price, part 4: additional predictors

What to look for in
regression output

What’s a good
value for R-squared?

What's the bottom
line? How to compare models

Testing the assumptions of linear regression

Additional notes on regression analysis

Stepwise and all-possible-regressions

Excel file with
simple regression formulas

Excel file with regression formulas
in matrix form

If you are a PC Excel user, you *must* check this out:

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

**Introduction to linear
regression analysis**

Justification
for regression assumptions

Correlation
and simple regression formulas

Linear
regression analysis is the most widely used of all statistical techniques: it
is the study of *linear*, *additive *relationships
between variables. Let Y denote the “dependent” variable whose
values you wish to predict, and let X_{1},
…,X_{k}
denote the “independent” variables from which you wish to predict
it, with the value of variable X_{i}
in
period t
(or in row t
of the data set) denoted by X_{it}. Then the equation for computing the predicted
value of Y_{t} is:

This formula has the property that the
prediction for Y is a straight-line
function of each of the X variables, holding
the others fixed, and the contributions of different X variables to the predictions are additive. The slopes of their individual
straight-line relationships with Y are the constants **b _{1}**,

The first thing you ought to know about
linear regression is how the strange term *regression* came to be applied
to models like this. They were first studied in depth by a 19th-Century
scientist, **Sir Francis Galton.**
Galton was a self-taught naturalist, anthropologist, astronomer, and
statistician--and a real-life Indiana Jones character. He was famous for his
explorations, and he wrote a best-selling book on how to survive in the
wilderness entitled "The Art of Travel: Shifts and Contrivances Available in
Wild Places," and its sequel, "The Art of *Rough* Travel: From the
Practical to the Peculiar." They are still in print and still considered
as useful resources. They provide
many handy hints for staying alive--such as how to treat spear wounds or
extract your horse from quicksand--and introduced the concept of the sleeping
bag to the Western World. Click on
these pictures for more details:

Galton
was a pioneer in the application of statistical methods to measurements in many
branches of science, and in studying data on relative sizes of parents and
their offspring in various species of plants and animals, he observed the
following phenomenon: a larger-than-average parent tends to produce a
larger-than-average child, but the child is likely to be *less* large than
the parent in terms of its relative position within its *own* generation. Thus, for example, if the parent's size is** ****x** standard deviations from the mean within its own
generation, then you should predict that the child's size will be** ****rx** (r times x) standard deviations from the mean within
the set of children of those parents, where **r** is a number *less
than 1 in magnitude*. (**r** is what will be defined below as the *correlation
*between the size of the parent and the size of the child.) The same is true
of virtually *any* physical measurement (and in the case of humans, most
measurements of cognitive and physical ability) that can be performed on
parents and their offspring. Here is
the first published picture of a regression line illustrating this effect, from
a lecture presented by Galton in 1877:

The R
symbol on this chart (whose value is 0.33) denotes the slope coefficient, not
the correlation, although the two are the same if both populations have the
same standard deviation, as will be shown below.

Galton
termed this phenomenon a *regression
towards mediocrity*, which in modern terms is a ** regression to the mean.** To a naïve observer this might
suggest that later generations are going to exhibit less variability--literally
more mediocrity--than earlier ones, but that is not case. It is a purely statistical phenomenon.
Unless every child is

Regression
to the mean is an inescapable fact of life. Your children can be *expected*
to be less exceptional (for better or worse) than you are. Your score on a
final exam in a course can be *expected* to be less good (or bad) than
your score on the midterm exam, relative to the rest of the class. A baseball
player's batting average in the second half of the season can be *expected*
to be closer to the mean (for all players) than his batting average in the
first half of the season. And so on. The key word here is "expected."
This does not mean it's *certain* that regression to the mean will occur,
but that's the way to bet!

We have
already seen a suggestion of regression-to-the-mean in some of the time series
forecasting models we have studied: plots of forecasts tend to be* smoother*--i.e.,
they exhibit less variability--than the plots of the original data. This is not
true of random walk models, but it is generally true of moving-average models
and other models that base their forecasts on more than one past observation.

The
intuitive explanation for the regression effect is simple: the thing we are
trying to predict usually consists of a predictable component
("signal") and a statistically independent *unpredictable*
component ("noise"). The best we can hope to do is to predict (only)
that part of the variability which is due to the signal. Hence our forecasts
will tend to exhibit less variability than the actual values, which implies a
regression to the mean.

Another
way to think of the regression effect is in terms of *selection bias*. In general a player’s performance over any
given period of time can be attributed to a combination of skill and luck.
Suppose that we select a sample of professional athletes whose performance was
much better than average (or students whose grades were much better than
average) in the first half of the year.
The fact that they did so well in the first half of the year makes it
probable that *both* their skill and their luck were better than average
during that period. In the second half of the year we may expect them to be
equally skillful, but we should not expect them to be equally lucky. So we
should predict that in the second half their performance will be closer to the
mean. Meanwhile, players whose
performance was merely average in the first half probably had skill and luck
working in opposite directions for them.
We should therefore expect their performance in the second half to move
away from the mean in one direction or another, as we get another independent
test of their skill. We don’t
know *which* direction they will move,
though, so even for them we should predict that their second half performance
will be closer to the mean than their first half performance. However, the *actual* performance of the players should be expected to have an *equally large variance *in the second
half of the year as in the first half, because it merely results from a
redistribution of independently random luck among players with the same
distribution of skill as before.

A nice
discussion of regression to the mean in the broader context of social science
research can be found here. (Return to top of page.)

**Justification for
regression assumptions**

Why should
we assume that relationships between variables are ** linear**?

- Because
linear relationships are the
*simplest non-trivial relationships*that can be imagined (hence the easiest to work with), and.....

- Because
the "true" relationships between our variables are often at
least
*approximately*linear over the range of values that are of interest to us, and...

- Even
if they're not, we can often
*transform*the variables in such a way as to linearize the relationships.

This is a strong assumption, and the first step in
regression modeling should be to look at scatterplots of the variables (and in
the case of time series data, plots of the variables vs. time), to make sure it
is reasonable a priori. And after
fitting a model, plots of the errors should be studied to see if there are
unexplained nonlinear patterns. This is especially important when the goal is
to make predictions for scenarios outside the range of the historical data,
where departures from perfect linearity are likely to have the biggest
effect. If you see evidence of
nonlinear relationships, it is possible (though not guaranteed) that
transformations of variables will straighten them out in a way that will yield
useful inferences and predictions via linear regression. (Return
to top of page.)

And why should we assume that the effects of different
independent variables on the expected value of the dependent variable are ** additive**? This is a

Many users just throw a lot of independent variables into
the model without thinking carefully about this issue, as if their software
will automatically figure out exactly how they are related. It
won’t! Even automatic model-selection methods (e.g., stepwise regression) require
you to have a good understanding of your own data and to use a guiding hand in
the analysis. They work only with
the variables they are given, in the form that they are given, and then they
look only for linear, additive patterns among them in the context of each
other. **A regression model does not merely assume that Y is "some
function" of the X's. It
assumes that it is a very special kind
of function of the X's. ** A
common practice is to include independent variables whose predictive effects
logically cannot be additive, say, some that are totals and others that are
rates or percentages. Sometimes
this can be rationalized by local first-order-approximation arguments, and
sometimes it can't.

*You* need to collect the relevant data, understand what it
measures, clean it up if necessary, perform descriptive analysis to look for
patterns before fitting any models, and study the diagnostic tests of model
assumptions afterward, especially statistics and plots of the errors. You should also try to apply the
appropriate economic or physical reasoning to determine whether an additive
prediction equation makes sense. Here too, it is possible (but not guaranteed)
that transformations of variables or the inclusion of interaction terms might
separate their effects into an additive form, if they do not have such a form
to begin with, but this requires some thought and effort on your part. (Return
to top of page.)

And why
should we assume the *errors *of linear
models are ** independently and identically normally distributed**?

1. This assumption is often justified by appeal to the **Central
Limit Theorem*** *of statistics, which states that the *sum** or average* of a sufficiently large
number of independent random variables--whatever their individual
distributions--approaches a normal distribution. Much data in business and economics
and engineering and the natural sciences is obtained by adding or averaging
numerical measurements performed on many different persons or products or
locations or time intervals. Insofar as the activities that generate the
measurements may occur somewhat randomly and somewhat independently, we might
expect the variations in the totals or averages to be somewhat normally
distributed.

2. It is (again) mathematically convenient: it implies that the
optimal coefficient estimates for a linear model are those that minimize the *mean
squared error* (which are easily calculated), and it justifies the use of a
host of statistical tests based on the normal family of distributions. (This
family includes the t distribution, the F distribution, and the Chi-square distribution.)

3. Even if the "true" error process is not normal in
terms of the original units of the data, it may be possible to transform the
data so that your model's prediction errors are approximately normal.

But here too caution must be exercised. Even if the unexplained variations in
the dependent variable are approximately normally distributed, it is not
guaranteed that they will also be*
identically* normally distributed for all values of the independent
variables. Perhaps the unexplained
variations are larger under some conditions than others, a condition known as "heteroscedasticity". For example, if the dependent variable consists of daily
or monthly total sales, there are probably significant day-of-week patterns or
seasonal patterns. In such cases
the variance of the total will be larger on days or in seasons with greater
business activity--another consequence of the central limit theorem. (Variable
transformations such as logging and/or seasonal adjustment are often used to
deal with this problem.) It is also
not guaranteed that the random variations will be statistically
independent. This is an especially
important question when the data consists of *time series*: if the
model is not correctly specified, it is possible that consecutive errors (or
errors separated by some other number of periods) will have a systematic
tendency to have the same sign or a systematic tendency to have opposite signs,
a phenomenon known as "autocorrelation"
or "serial correlation".

A very
important special case is that of **stock
price data**, in which percentage changes rather than absolute changes tend
to be normally distributed. This
implies that over moderate to large time scales, movements in stock prices are *lognormally *distributed rather than
normally distributed. A log transformation is
typically applied to historical stock price data when studying growth and
volatility. Caution: although simple regression models are
often fitted to historical stock returns to estimate "betas", which
are indicators of relative risk in the context of a diversified portfolio, I do
not recommend that you use regression to try to predict *future* stock returns.
See the geometric
random walk page instead.

You still
might think that variations in the values of*
portfolios* of stocks would tend to be normally distributed, by virtue of
the central limit theorem, but the central limit theorem is actually rather
slow to bite on the lognormal distribution because it is so asymmetrically
long-tailed. **A sum of 10 or 20 independently and identically lognormally distributed
variables has a distribution that is still quite close to lognormal. ** If you don’t believe this, try
testing it by Monte Carlo simulation:
you’ll be surprised.
(I was.)

Because the assumptions of linear regression (linear,
additive relationships with i.i.d. normally distributed errors) are so strong,
it is very important to test their validity when fitting models, a topic
discussed in more detail on the
testing-model-assumptions page, and be alert to the possibility that you
may need more or better data to accomplish your objectives. You can’t get something from
nothing. All too often, naïve users
of regression analysis view it as a black box that can automatically predict
any given variable from any other variables that are fed into it, when in fact
a regression model is a very special and very transparent kind of prediction
box. Its output contains no more
information than is provided by its inputs, and its inner mechanism needs to be
compared with reality in each situation where it is applied. (Return
to top of page.)

**Correlation and
simple regression formulas**

A **variable**
is, by definition, *a quantity that may vary* from one measurement to
another in situations where different samples are taken from a population or
observations are made at different points in time. In fitting statistical models in which
some variables are used to predict others, what we hope to find is that the
different variables do *not* vary *independently* (in a statistical
sense), but that they tend to vary *together*.

In
particular, when fitting *linear* models, we hope to find that one
variable (say, Y) is varying as a *straight-line*
function of another variable (say, X). In other words,
if all other possibly-relevant variables could be held fixed, we would hope to
find the *graph* of Y versus X to be a straight line (apart from the inevitable
random errors or "noise").

A measure
of the absolute amount of variability in a variable is (naturally) its **variance**,
which is defined as its *average squared deviation from its own mean*.
Equivalently, we can measure variability in terms of the **standard deviation**,
which is defined as the square root of the variance. The standard deviation has
the advantage that it is measured in the same units as the original variable,
rather than squared units.

Our task
in predicting Y might be described
as that of explaining some or all of its variance--i.e., *why*, or under
what conditions, does it deviate from its mean? Why is it not constant? That
is, we would like to be able to improve on the naive predictive model: Ŷ_{t} = CONSTANT, in which the best value for
the constant is presumably the historical mean of Y. More precisely, *we hope to find a model whose
prediction errors are smaller, in a mean square sense, than the deviations of
the original variable from its mean*.

In using *linear*
models for prediction, it turns out very conveniently that the *only*
statistics of interest (at least for purposes of estimating coefficients to
minimize squared error) are the mean and variance of each variable and the **correlation
coefficient*** *between each pair of variables. The coefficient of
correlation between X and Y is commonly denoted by **r**** _{XY}**, and it measures the strength of the linear relationship
between them on a relative (i.e., unitless) scale of -1 to +1. That is, it
measures the extent to which a linear model can be used to predict the
deviation of one variable from its mean given knowledge of the other's
deviation from its mean at the same point in time.

The correlation coefficient is most easily
computed if we first **standardize** the variables, which means to convert
them to units of standard-deviations-from-the-mean, using the *population* standard deviation rather
than the sample standard deviation, i.e., using the statistic whose formula has
n rather
than n-1
in the denominator, where n is the sample size. The standardized version of X will be denoted
here by X^{*}, and its value in
period t
is defined in Excel notation as:

...where **STDEV.P** is the Excel function for the population
standard deviation. (Here and
elsewhere I am going to use Excel functions rather than conventional math
symbols in some of the formulas to illustrate how the calculations would be
done on a spreadsheet.) For
example, suppose that AVERAGE(X)
= 20 and STDEV.P(X)
= 5.
If X_{t}
= 25,
then X^{*}_{t} = 1, if X_{t} = 10, then X^{*}_{t}
= -2,
and so on. Y^{*} will denote the similarly standardized
value of Y.

Now, **the
correlation coefficient is equal to the average product of the standardized
values** of the two variables within the given sample of n observations:

Thus, for
example, if X and Y are stored in columns on a spreadsheet, you can use
the AVERAGE and STDEV.P functions to compute
their averages and population standard deviations, then you can create two new
columns in which the values of X^{*} and Y^{*} in each row are computed according to the
formula above. Then create a third new column in which X^{*} is multiplied by Y^{*} in every row. The average of the values in
the last column is the correlation between X and Y. Of course, in Excel, you can just use the formula **=CORREL(X,Y)** to calculate a
correlation coefficient, where X and Y denote the cell ranges of the data for the variables. (Note: in some situations it might be of
interest to standardize the data relative to the *sample* standard deviation, which is STDEV.S in Excel, but the
population statistic is the correct one to use in the formula above.) (Return to top of page.)

If the two
variables tend to vary on the *same sides* of their respective means at
the same time, then the average product of their deviations (and hence the
correlation between them) will be *positive*, since the product of two
numbers with the same sign is positive. Conversely, if they tend to vary on *opposite*
sides of their respective means at the same time, their correlation will be *negative*.
If they vary *independently* with respect to their means--that is, if one
is equally likely to be above or below its mean regardless of what the other is
doing--then the correlation will be *zero*. And if Y is an exact linear
function of X, then either Y^{*}_{t}
= X^{*}_{t} for all t or else Y^{*}_{t} = -X^{*}_{t} for all t, in which case the formula for the
correlation reduces to +1 or -1.

The correlation
coefficient can be said to measure the strength of the *linear *relationship between Y and X for the following reason. The linear equation for predicting Y^{*} from X^{*} that *minimizes mean squared error* is simply:

Thus, if X is observed to be 1 standard deviation above its own
mean, then we should predict that Y will be r_{XY} standard deviations above its own mean; if
X is 2 standard deviations below its own
mean, then we should be predict that Y will be 2r_{XY} standard deviations below its own mean,
and so on.

In
graphical terms, this means that, **on a
scatterplot of ****Y ^{*}**

Here is an
example: on a scatterplot of Y^{*} versus X^{*}, the visual axis
of symmetry is a line that passes through the origin and whose slope is equal
to 1 (i.e., a 45-degree line), which is the gray dashed line on the plot
below. It passes through the origin
because the means of both standardized variables are zero, and its slope is
equal to 1 because their standard deviations are both equal to 1. (The latter
fact means that the points are equally spread out horizontally and vertically
in terms of mean squared deviations from zero, which forces their pattern to
appear roughly symmetric around the 45-degree line if the relationship between
the variables really is linear.)
However, the gray dashed line is the not the best line to use for
predicting the value of Y^{*} for a given value
of X^{*}. The best line for predicting Y^{*} from X^{*} has a slope of
less than 1:* it regresses toward the **X** axis*.
The regression line is shown in red, and its slope is the correlation
between X and Y,
which is 0.46 in this case. Why is
this true? Because, that’s
the way to bet if you want to minimize the mean squared error *measured in the **Y** direction*.
If instead you wanted to predict X^{*} from Y^{*} so as to minimize mean squared error
measured in the X direction, the
line would regress in the other direction relative to the 45-degree line, and
by exactly the same amount.

If we want to obtain the linear regression
equation for predicting Y from X in *unstandardized terms*, we just need to
substitute the formulas for the standardized values in the preceding equation,
which then becomes:

By rearranging
this equation and collecting constant terms, we obtain:

where:

is the
estimated slope of the regression line, and

is the
estimated Y-intercept of the line.

Notice
that, as we claimed earlier, the coefficients in the linear equation for
predicting Y from X depend only on the means and standard deviations of X and Y and on their coefficient of correlation.

The
additional formulas that are needed to compute *standard errors*, *t-statistics*,
and *P-values* (statistics that measure
the precision and significance of the estimated coefficients) are given in the notes on mathematics of simple
regression and also illustrated in this spreadsheet
file.

*Perfect* positive
correlation (r_{XY} = +1) or perfect
negative correlation (r_{XY} = -1) is only
obtained if one variable is an *exact* linear function of the other,
without error, in which case they aren't really "different" variables
at all.

In general
we find less-than-perfect correlation, which is to say, we find that r_{XY} is less than 1 in absolute value.
Therefore our prediction for Y^{*} is typically *smaller*
in absolute value than our observed value for X^{*}.
That is, **the prediction for ****Y**** is always closer to its own mean, in units of its own
standard deviation, than ****X*** ***was observed to be, which is Galton's phenomenon of
regression to the mean. **

So, the
technical explanation of the regression-to-the-mean effect hinges on two mathematical
facts: (i) the correlation coefficient, calculated in the manner described
above, happens to be the coefficient that minimizes the squared error in
predicting Y^{*} from X^{*}, and (ii) the correlation coefficient is
never larger than 1 in absolute value, and it is only equal to 1 when Y^{*} is an exact (noiseless) linear function of
X^{*}.

The term
"regression" has stuck and has even mutated from an intransitive verb
into a transitive one since Galton's time. We don't merely say that the
predictions for Y "regress to
the mean"--we now say that we are "regressing Y on X" when we
estimate a linear equation for predicting Y from X, and we refer to X as a
"regressor" in this case.

When we
have fitted a linear regression model, we can compute the variance of its
errors and compare this to the variance of the dependent variable (the latter
being the error variance of an intercept-only model). The relative amount by which the
regression model's error variance is less than the variance of the dependent
variable is referred to as the *fraction* of the variance that was *explained* by the independent variable(s). For
example, if the error variance is 20% less than the original variance, we say
we have "explained 20% of the variance."

It turns
out that **in a simple regression model,** **the fraction of variance
explained is precisely the square of the correlation coefficient**--i.e., the
square of r.
Hence, the fraction-of-variance-explained has come to be known as **"R-squared".** The interpretation and use of R-squared
are discussed in more detail here.

In a *multiple*
regression model (one with two or more
X variables), there are many
correlation coefficients that must be computed, in addition to all the means
and variances. For example, we must consider the correlation between *each*
X variable and the Y variable, and also the correlation between each *pair*
of X variables. In this case, it still turns
out that the model coefficients and the fraction-of-variance-explained
statistic can be computed entirely from knowledge of the means, standard
deviations, and correlation coefficients among the variables--but the
computations are no longer easy. We will leave those details to the
computer. (Return
to top of page.)

Go on to a
nearby topic:

·
Mathematics of
simple regression

·
Example #1: baseball batting averages

·
What to look for in regression output