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.
Cory Mitchell has been a writer since 2007. His articles have been published by "Stock and Commodities" magazine and Forbes Digital. He is a Chartered Market Technician and a member of the Market Technicians Association and the Canadian Society of Technical Analysts. Mitchell holds a Bachelor of Management in finance from the University of Lethbridge.