R squared value investing definition

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Definition and Example of R-Squared R-squared is one of the most basic measuring tools for mutual fund analysis. It is a metric you can use to assess the degree to which a given fund matches its benchmark. Alternate name: Coefficient of determination Acronym: R2 R-squared does not measure how well a mutual fund or your portfolio performs.

Instead, it compares your portfolio's returns to a benchmark and expresses that as a percentage between 1 and The higher the figure, the more your portfolio mirrors the index or benchmark. On May 24, , the fund had an R-squared of Note Some funds do not attempt to track an index but rather invest in companies in a sector without a comparative index. How Does R-Squared Work? As a statistical measurement, R-squared expresses the relationship between two data sets generally used in a simple linear regression model.

By Marios Alexandrou. Whether you're investing in individual stocks or baskets of them via mutual funds and exchange traded funds ETFs , it's important to understand the terminology used in the investing world. This knowledge can help you decipher the jargon you're likely to encounter from investment-related news in newspapers, blogs, and on TV. Two common terms that I see used a lot are Alpha and Beta.

Their definitions are below. Alpha A mathematical estimate of the amount of return expected from an investment's inherent values. It measures the difference between a stock's actual performance and the performance anticipated in light of the stock's risk and the behavior of the market.

Alpha measure's a stock's risk adjusted performance. That is, it measures a stock's performance taking into account its beta, or sensitivity to the index, and the risk-free rate of return of a three-month Treasury Bill.

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The higher the figure, the more your portfolio mirrors the index or benchmark. On May 24, , the fund had an R-squared of Note Some funds do not attempt to track an index but rather invest in companies in a sector without a comparative index. How Does R-Squared Work? As a statistical measurement, R-squared expresses the relationship between two data sets generally used in a simple linear regression model.

When used to evaluate mutual funds, returns from the fund and the index it tracks are the data sets. Several steps are necessary to calculate a fund's R-squared, so it's best to view your fund's performance information where the value is generally published.

Put simply, variances—the spread between numbers in a data set—are used to determine R-squared. Brokerages generally show a fund's R-squared on its page, so you're not required to run a regression yourself to find the value. From there, divide the first sum of errors unexplained variance by the second sum total variance , subtract the result from one, and you have the R-squared.

What R-Squared Can Tell You In investing, R-squared is generally interpreted as the percentage of a fund or security's movements that can be explained by movements in a benchmark index. For example, an R-squared for a fixed-income security versus a bond index identifies the security's proportion of price movement that is predictable based on a price movement of the index.

It may also be known as the coefficient of determination. A higher R-squared value will indicate a more useful beta figure. R-Squared vs. Adjusted R-Squared R-Squared only works as intended in a simple linear regression model with one explanatory variable. With a multiple regression made up of several independent variables, the R-Squared must be adjusted.

The adjusted R-squared compares the descriptive power of regression models that include diverse numbers of predictors. Every predictor added to a model increases R-squared and never decreases it. Thus, a model with more terms may seem to have a better fit just for the fact that it has more terms, while the adjusted R-squared compensates for the addition of variables and only increases if the new term enhances the model above what would be obtained by probability and decreases when a predictor enhances the model less than what is predicted by chance.

In an overfitting condition, an incorrectly high value of R-squared is obtained, even when the model actually has a decreased ability to predict. This is not the case with the adjusted R-squared. Beta Beta and R-squared are two related, but different, measures of correlation but the beta is a measure of relative riskiness. A mutual fund with a high R-squared correlates highly with a benchmark. If the beta is also high, it may produce higher returns than the benchmark, particularly in bull markets.

R-squared measures how closely each change in the price of an asset is correlated to a benchmark. Beta measures how large those price changes are relative to a benchmark. Used together, R-squared and beta give investors a thorough picture of the performance of asset managers.

A beta of exactly 1.