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Week 13 November 24-28 Three Mini-Lectures QMM 510 Fall 2014

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13-2 Multicollinearity ML 13.1 Multicollinearity occurs when the independent variables X 1, X 2, …, X m are intercorrelated instead of being independent.Multicollinearity occurs when the independent variables X 1, X 2, …, X m are intercorrelated instead of being independent. Collinearity occurs if only two predictors are correlated.Collinearity occurs if only two predictors are correlated. The degree of multicollinearity is the real concern.The degree of multicollinearity is the real concern. What Is Multicollinearity? What Is Multicollinearity? Chapter 13

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13-3 Chapter 13 Variance Inflation Variance Inflation Multicollinearity induces variance inflation in the estimation of the regression model coefficients.Multicollinearity induces variance inflation in the estimation of the regression model coefficients. This results in wider confidence intervals for the true coefficients 1, 2, …, k and makes the t statistic less reliable.This results in wider confidence intervals for the true coefficients 1, 2, …, k and makes the t statistic less reliable. The separate contribution of each predictor in “explaining” the response variable is difficult to identify.The separate contribution of each predictor in “explaining” the response variable is difficult to identify. Multicollinearity

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13-4 To check whether two predictors are correlated (collinearity), inspect the correlation matrix using Excel, MegaStat, or MINITAB. For example, Correlation Matrix Correlation Matrix Chapter 13Multicollinearity

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13-5 Variance Inflation Factor (VIF) Variance Inflation Factor (VIF) The matrix scatter plots and correlation matrix only show correlations between any two predictors.The matrix scatter plots and correlation matrix only show correlations between any two predictors. The variance inflation factor (VIF) is a more comprehensive test for multicollinearity.The variance inflation factor (VIF) is a more comprehensive test for multicollinearity. For a given predictor j, the VIF is defined asFor a given predictor j, the VIF is defined as where R j 2 is the coefficient of determination when predictor j is regressed against all other predictors. Chapter 13Multicollinearity

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13-6 Variance Inflation Factor (VIF) Variance Inflation Factor (VIF) Some possible situations are: Chapter 13Multicollinearity

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13-7 Rules of Thumb Rules of Thumb There is no limit on the magnitude of the VIF.There is no limit on the magnitude of the VIF. A VIF of 10 says that the other predictors “explain” 90% of the variation in predictor j.A VIF of 10 says that the other predictors “explain” 90% of the variation in predictor j. A high VIF indicates that predictor j is strongly related to the other predictors.A high VIF indicates that predictor j is strongly related to the other predictors. However, a high is not necessarily indicative of instability in the least squares estimate.However, a high is not necessarily indicative of instability in the least squares estimate. A large VIF is a warning to consider whether predictor j really belongs to the model.A large VIF is a warning to consider whether predictor j really belongs to the model. Chapter 13Multicollinearity

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13-8 Are Coefficients Stable? Are Coefficients Stable? Evidence of instability is when X 1 and X 2 have a high pairwise correlation with Y, yet one or both predictors have insignificant t statistics in the fitted multiple regression, and/or if X 1 and X 2 are positively correlated with Y, yet one has a negative slope in the multiple regression.Evidence of instability is when X 1 and X 2 have a high pairwise correlation with Y, yet one or both predictors have insignificant t statistics in the fitted multiple regression, and/or if X 1 and X 2 are positively correlated with Y, yet one has a negative slope in the multiple regression. As a test, try dropping a collinear predictor from the regression and see what happens to the fitted coefficients in the re-estimated model.As a test, try dropping a collinear predictor from the regression and see what happens to the fitted coefficients in the re-estimated model. If they don’t change much, then multicollinearity is not a concern.If they don’t change much, then multicollinearity is not a concern. If there are sharp changes in one or more of the remaining coefficients in the model, then multicollinearity may be causing instability.If there are sharp changes in one or more of the remaining coefficients in the model, then multicollinearity may be causing instability. Chapter 13Multicollinearity

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12-9 Tests of Assumptions 13.2 Three Important Assumptions Three Important Assumptions 1.The errors are normally distributed. 2.The errors have constant variance (i.e., they are homoscedastic). 3.The errors are independent (i.e., they are nonautocorrelated). Chapter 13 Note: Everything you learned about residual tests in Chapter 12 is still true, except that the residuals are now based on multiple predictors (k > 2). This may affect the degrees of freedom in some tests, but the concepts are basically the same.

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12-10 Chapter 13 Tests for Non-Normal Errors Tests for Non-Normal Errors Quick test: Make a histogram of residuals. Is it bell-shaped? Outliers?Quick test: Make a histogram of residuals. Is it bell-shaped? Outliers? For a more precise test, use the normal probability plot. If H 0 is true, the residual plot should be linear.For a more precise test, use the normal probability plot. If H 0 is true, the residual plot should be linear. H 0 : Errors are normally distributed H 1 : Errors are not normally distributed Residual Tests Non-Normal Errors Non-Normal Errors Non-normality of errors is a mild violation since the parameter estimates and their variances remain unbiased and consistent.Non-normality of errors is a mild violation since the parameter estimates and their variances remain unbiased and consistent. Confidence intervals for the parameters may be untrustworthy because the normality assumption is used to justify using Student’s t.Confidence intervals for the parameters may be untrustworthy because the normality assumption is used to justify using Student’s t.

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12-11 Chapter 13 Residual Tests Example: Normality Test (n = 50, k = 7) Example: Normality Test (n = 50, k = 7) MegaStat’s normal probability plot is somewhat linear, but has some weird values at either end. Possible non- normal residuals? But a histogram of residuals from Minitab's Stat > Graphical Summary is arguably normal in shape. From its p-value (.24) we would not reject normality. Note that the mean of the residuals is zero, as it must be.

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12-12 Heteroscedastic Errors (Nonconstant Variance) Heteroscedastic Errors (Nonconstant Variance) Ideally, the error magnitude is constant (i.e., homoscedastic errors). Heteroscedastic errors increase or decrease with X.Ideally, the error magnitude is constant (i.e., homoscedastic errors). Heteroscedastic errors increase or decrease with X. In multiple regression, we have several X’s, so for simplicity we often just plot the n residuals against the fitted Y values.In multiple regression, we have several X’s, so for simplicity we often just plot the n residuals against the fitted Y values. In the most common form of heteroscedasticity, the variances of the estimators may be understated, the t-statistics overstated, and confidence intervals artificially narrow.In the most common form of heteroscedasticity, the variances of the estimators may be understated, the t-statistics overstated, and confidence intervals artificially narrow. Chapter 13 Tests for Heteroscedasticity Tests for Heteroscedasticity Plot the residuals against Y fitted or against each of the k predictors. Ideally, there is no pattern in the residuals moving from left to right.Plot the residuals against Y fitted or against each of the k predictors. Ideally, there is no pattern in the residuals moving from left to right. Residual Tests

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12-13 Chapter 13 Example: Regression with 7 Predictors Example: Regression with 7 Predictors Plots of residuals against Y fitted (shown below in blue) or against each of the k predictors (shown below in pink) show evidence of heteroscedasticity. Note that one predictor was binary (X = 0 or 1).Plots of residuals against Y fitted (shown below in blue) or against each of the k predictors (shown below in pink) show evidence of heteroscedasticity. Note that one predictor was binary (X = 0 or 1). Residual Tests

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12-14 Chapter 13 Autocorrelated Errors Autocorrelated Errors Autocorrelation is a pattern of non-independent errors. It is of more concern in time series data because the natural order of the data is meaningful (whereas in cross-sectional data the order of observatiohs if often alphabetical or randomized). In a first-order autocorrelation, e t is correlated with e t 1. The estimated variances of the OLS estimators are biased, resulting in confidence intervals that are too narrow, overstating the model’s fit. Residual Tests

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12-15 Runs Test for Autocorrelation Runs Test for Autocorrelation Look at a plot of residuals over time (or by observation). Count the number of sign reversals (i.e., how often does the residual cross the zero centerline?).Look at a plot of residuals over time (or by observation). Count the number of sign reversals (i.e., how often does the residual cross the zero centerline?). If the pattern is random, the number of sign changes should be near n/2.If the pattern is random, the number of sign changes should be near n/2. Fewer than n/2 would suggest positive autocorrelation.Fewer than n/2 would suggest positive autocorrelation. More than n/2 would suggest negative autocorrelation.More than n/2 would suggest negative autocorrelation. Chapter 13 Durbin-Watson (DW) Test Durbin-Watson (DW) Test Tests for autocorrelation under the hypotheses H 0 : Errors are non-autocorrelated H 1 : Errors are autocorrelated The DW statistic will range from 0 to 4. DW 2 suggests negative autocorrelation Residual Tests

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12-16 Here is MegaStat’s plot of residuals by observation (n = 50). Count the number of sign reversals (i.e., how often does the residual cross the zero centerline). If the pattern is random, the number of sign changes should be near n/2 and the Durbin-Watson statistic should be near 2.Here is MegaStat’s plot of residuals by observation (n = 50). Count the number of sign reversals (i.e., how often does the residual cross the zero centerline). If the pattern is random, the number of sign changes should be near n/2 and the Durbin-Watson statistic should be near 2. Chapter 13 Residual Tests Example: Normality Test (n = 50, k = 7) Example: Normality Test (n = 50, k = 7) 28 sign changes (close to n/2 = 50/2 = 25) so there is not much evidence of autocorrelation. DW is near 2 so there is not much evidence of autocorrelation.

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12-17 Example: Excel’s Tests of Assumptions Example: Excel’s Tests of Assumptions Chapter 13 Residual Tests Warning: Warning: Excel offers normal probability plots for residuals, but they are done incorrectly. Excel’s Data Analysis > Regression does residual plots (test for heteroscedasticity) and gives the DW test statistic. Excel’s standardized residuals are done in a strange way, but usually they are not misleading.

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12-18 Example: MegaStat’s Tests of Assumptions Example: MegaStat’s Tests of Assumptions Chapter 13 Residual Tests MegaStat will do all three tests (if you check the boxes). Its runs plot (residuals by observation) is a visual test for autocorrelation, which Excel does not offer.

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13-19 Other Regression Topics ML 13.3 Chapter 13 Outliers? (omit only if clearly errors) Missing Predictors? (usually you can’t tell) Ill-Conditioned Data (adjust decimals or take logs) Significance in Large Samples? (if n is huge, any regression will be significant) Model Specification Errors? (may show up in residual patterns) Missing Data? (we may have to live without it) Binary Response? (if Y = 0,1 we use logistic regression) Stepwise and Best Subsets Regression (MegaStat does these)

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13-20 Sometimes the effect of a predictor is nonlinear. A simple example would be estimating the volume of lumber to be obtained from a tree. To test for suspected nonlinearity of any predictor variable, we can include its square in the regression. Tests for Nonlinearity Tests for Nonlinearity Chapter 13 Tests for Nonlinearity and Interaction Tests for Interaction Tests for Interaction We can test for interaction between two predictors by including their product in the regression. Model with x 1 x 2 interaction term.

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13-21 Tests for Nonlinearity Tests for Nonlinearity Chapter 13 Tests for Nonlinearity and Interaction

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13-22 Example: MegaStat Example: MegaStat Chapter 13 Stepwise Regression Caution: Caution: This is basically a data-mining tool that looks only at fit (not at causal logic). Use it only as a check.

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13-23 Chapter Summary Chapter 13

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13-24 Chapter Summary Chapter 13

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