Definition: The coefficient of determination, often referred to as r squared or r 2, is a dependent variable’s percentage of variation explained by one or more related independent variables. In other words, it’s a statistical method used in finance to explain how the changes in an independent variable like an index change a dependent variable like a specific portfolio’s performance.
What Does Coefficient of Determination Mean?
I know this sounds complicated, but it’s quite simple. You can think of it like the change in X explained by Y. Investors and analysts use this calculation to track finance trends and speculate how well investments will perform in the future.
Example
It’s important to note that r squared does not actually measure the performance of an investment. It simply calculates the relationship between an investment and something else like an index benchmark. The higher the coefficient of determination is the more likely the investment will change as the benchmark index changes. The standard r 2 scale is measure from 1 to 100 with 100 being the highest indicator of variation correlation.
The scale is basically a percentage measurement of the correlation between the two variables. If the r squared rate is 50 percent, it means that half of the investment changes can be explained by the variations in the index benchmark. Investors that find an investment with a coefficient of 100 can completely rely on the index to understand the changes in the stock price or investment performance. In other words, they don’t even need to look at the stock itself when making investment decisions. They can simply refer back to the index because the stock is so closely tied to the index that its up and down swings will mirror the index.
Investors can also use this correlation to trend out performance into the future using the index’s historical performance in an effort to beat the market.
