Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Goodness of Fit

What it is:

Goodness of fit is a statistical term referring to how far apart the expected values of a financial model are from the actual values.

How it works (Example):

Goodness of fit is a component of regression analysis, which is a statistical method used in finance and a variety of other fields to make predictions based on observed values. In other words, it is a measure of how correlated a group of actual observations are to a model's predictions.

In the following examples, the blue dots represent actual observations. The black lines represent a regression line, which is represented by the formula in the top right-hand corner of each chart. This formula is what analysts use to predict future values based on the behavior of the actual observations.

As you can see, this regression line has a high goodness of fit as represented by a high R2 value of 79%:

goodness of fit chart example

This next chart is an example of low goodness of fit. Here, the formula for the regression line was virtually unable to come up with the observed values. Goodness of fit, as represented by R2, is only 0.38%:

goodness of fit chart example

Why it Matters:

Goodness of fit isn't just a statistical measure, it's a confidence measure. This is because when you've come up with a formula that accounts for most of the variations in a group of, say, price observations, you've also come up with a formula that can be a very reliable predictor of what prices will be in the future.

Related Terms View All
  • Auction Market
    Though most of the trading is done via computer, auction markets can also be operated via...
  • Best Execution
    Let's assume you place an order to buy 100 shares of Company XYZ stock. The current quote...
  • Book-Entry Savings Bond
    Savings bonds are bonds issued by the U.S. government at face values ranging from $50 to...
  • Break-Even Point
    The basic idea behind break-even point is to calculate the point at which revenues begin...
  • Calendar Year
    If Company XYZ starts its fiscal year on January 1 and ends its fiscal year on December...