If you are ready to invest, or you have made some investments already, understanding R-squared can help you create a portfolio customized to your needs. R-squared is a statistical measure that explains how much a stock or portfolio's movement can be attributed to a benchmark index. As you consider investing in different stocks, being aware of the R-squared value can help you weed out redundant holdings and build a truly diversified portfolio. You also can use R-squared to filter other risk and performance statistics. Beta and alpha calculations provide risk and performance figures, respectively, but they may not always be accurate depending on the R-squared value.
Also termed the "coefficient of determination," R-squared is a measure between one and 100 that determines what factors are most likely to affect the price of a stock in the future. You can use it to determine how likely it is that a stock you own will drop if the Standard & Poor's 500 index (or other variable) drops. If the R-squared relationship between the stock and the S&P 500 is 100, it means all movement of the stock can be attributed to the S&P 500's movements. An R-squared reading of 60 means 60 percent of the stock's movements are attributable to the index. Therefore, R-squared investing lets you know what factors are likely, or unlikely, to affect your holdings.
Cut the Redundancy
R-squared investing can help you cut redundant stocks from your portfolio. While holding many stocks may provide the illusion of diversification, if all the holdings have high R-squared values relative to an index, they all move together and provide little in the way of diversification. If most of the stocks in a portfolio have an R-squared of 85 or higher, you simply could purchase an index fund to replace those stocks. Replacing the high R-squared stocks with an index fund can save time and money on having to pay multiple commissions for individual stocks.
R-squared investing also can help you diversify. If a stock has an R-squared reading of less than 70, relative to an index, it means there are other factors at work and the index plays less of a role in the stock's (or portfolio's) performance. Building a portfolio of low R-squared stocks helps you achieve diversification because such a portfolio is unlikely to act like the index. If you want a portfolio that performs like the benchmark, buy stocks with high R-squared values relative to the index.
Test Other Measures
You also can examine other portfolio and stock statistics using R-squared. Beta is a common measure of systematic risk or volatility, but it may not provide an accurate reading if the R-squared is low. Alpha, a risk-adjusted performance measure, also is unlikely to provide a usable figure if the security or portfolio has a low R-squared rating. This is because the underlying benchmark used in the beta and alpha calculations does not have significant relevance to the stock or portfolio's movement to begin with.
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