Correlation & Regression Analysis

We have all heard investment managers discuss their low correlations, high alpha, and low beta, but what is the real meaning of these terms? All of them relate to how different investments react relative to one another.

  • The correlation coefficient (R) measures the extent of linear association of one or more funds or indices.
  • Alpha is a measure of value added by an investment relative to the market (i.e. an index) or to another investment.
  • Beta is a measure of the volatility of an investment relative to the market (i.e. an index) or to another investment.
  • The coefficient of determination (R2) measures how well the regression line fits the data. The R2 is the only measure that attempts to be predictive. The regression line is a graph of the mathematical relationship between two variables. In Figure 18, the regression line is the line of “best fit” drawn through a scatter plot, and represents a linear relationship between two investments.

Investors who are required to select and monitor investment managers should develop a basic understanding of investment statistics. Quantitative tools can provide you with good insight that you can use in your qualitative interviews with managers and when monitoring your investments.