In previous posts, we’ve discussed how when we look at comparing returns, it is important to make sure that we compare like to like. For example, when I look at my portfolio returns against the S&P 500 returns, both must have similar asset classes and composition. If not, then we’re comparing apples to broccoli. In our world, we calculate this similarity or measurement of fit as the coefficient of determination, denoted as R² (pronounced "r squared"). This metric is a statistical measure that quantifies the goodness of fit of a statistical model in predicting an outcome. Essentially, telling us whether the benchmark is a good comparison or not. This metric gives our team the data we need to ensure we’re measuring apples to apples and the broccoli is being measured against other broccoli.
How do we calculate it?
Calculating R² can be done in several ways, and all require in-depth calculations that I wouldn’t recommend by hand. In most cases, this metric is already calculated within the software we use. Morningstar, Charles Schwab, and Fidelity all have this and other key metrics automatically calculated. However, more complicated methods include linear regression, calculating with built-in formulas in Excel/spreadsheets, or the most complex, which all require large data sets to calculate manually.
How do we interpret it?
Interpreting R² involves understanding its implications as an effect size and its limitations. An R² of 0.71, for instance, implies that 71% of the variation in the dependent variable is explained by the independent variable, leaving 29% unexplained. Our internal guidelines are that R² values of 70% or greater are a good representation and fit for the measurement. However, it is important that once we define a good fit, we need to recognize that R² doesn't reveal the direction of the relationship or the presence of confounding variables. Therefore, as I say, with every metric we discuss, never make a decision based on one metric. The holistic picture must come together in order to make an informed decision.
In your portfolio
At Whitaker-Myers Wealth Managers, we use various tools and resources to support our clients. As a client, you have access to a long list of experts who work together to provide the best experience, research, and outcomes for all your financial planning needs. One of these teams, our internal research team, conducts in-depth analyses of our portfolios to stay within the parameters that we’ve defined for success.
If you’d like to meet with any of our team members, don’t hesitate to connect with your financial advisor. If you don’t have an advisor, connect with one of ours today! Our financial planning and coaching teams have continued to grow, and if you’re looking for an in-depth financial plan or the best advice to get out of debt, connect with our coaching team and planning teams.
The Coefficient of Correlation
February 25, 2025
Summit Puri
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