Least Squares Regression Method Definition

A least-squares regression method is a form of regression analysis that establishes the relationship between the dependent and independent variables along a linear line. This line refers to the “line of best fit.”

Regression analysis is a statistical method with the help of which one can estimate or predict the unknown values of one variable from the known values of another variable. The variable used to predict the variable interest is called the independent or explanatory variable, and the variable predicted is called the dependent or explained variable.

Let us consider two variables, x and y. These are plotted on a graph with values of x on the x-axis and y on the y-axis. The dots represent these values in the below graph. A straight line is drawn through the dots – referred to as the line of best fit.

The objective of least squares regression is to ensure that the line drawn through the set of values provided establishes the closest relationship between the values.

Least Squares Regression Formula

The regression line under the least squares method one can calculate using the following formula:

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Where,

  • ŷ = dependent variablex = independent variablea = y-interceptb = slope of the line

One can calculate the slope of line b using the following formula:

Or

Y-intercept, ‘a’ is calculated using the following formula:

Line of Best Fit in the Least Square Regression

The line of best fitLine Of Best FitThe line of best fit is a mathematical concept that correlates points scattered across a graph.read more

is a straight line drawn through a scatter of data points that best represents the relationship between them.

Let us consider the following graph wherein a data set plot along the x and y-axis. These data points represent using the blue dots. Three lines are drawn through these points – a green, a red, and a blue line. The green line passes through a single point, and the red line passes through three data points. However, the blue line passes through four data points, and the distance between the residual points and the blue line is minimal compared to the other two lines.

In the above graph, the blue line represents the line of best fit as it lies closest to all the values and the distance between the points outside the line to the line is minimal (the distance between the residuals to the line of best fit – also referred to as the sums of squares of residuals). However, in the other two lines, the orange and the green, the distance between the residuals and the lines is greater than the blue line.

The least-squares method provides the closest relationship between the dependent and independent variablesIndependent VariablesIndependent variable is an object or a time period or a input value, changes to which are used to assess the impact on an output value (i.e. the end objective) that is measured in mathematical or statistical or financial modeling.read more by minimizing the distance between the residuals, and the line of best fit, i.e., the sum of squares of residuals is minimal under this approach. Hence, the term “least squares.”

Examples of Least Squares Regression Line

Let us apply these formulae to the below question:

Example #1

The details about technicians’ experience in a company (in several years) and their performance rating are in the table below. Using these values, estimate the performance rating for a technician with 20 years of experience.

Solution –

To calculate the least squares first, we will calculate the Y-intercept (a) and slope of a line(b) as follows:

The slope of Line (b)

  • b = 6727 – [(80*648)/8] / 1018 – [(80)2/8]= 247/218= 1.13

Y-intercept (a)

  • a = 648 – (1.13)(80) /8= 69.7

The regression line is calculated as follows:

Substituting 20 for the value of x in the formula,

  • ŷ = a + bxŷ = 69.7 + (1.13)(20)ŷ = 92.3

The performance rating for a technician with 20 years of experience is estimated to be 92.3.

Example #2

Least Squares Regression Equation Using Excel

One can compute the least-squares regression equation using Excel by the following steps:

  • Insert data table in excelData Table In ExcelA data table in excel is a type of what-if analysis tool that allows you to compare variables and see how they impact the result and overall data. It can be found under the data tab in the what-if analysis section.read more.

  • Insert a scatter graph using the data points.

  • Insert a trendline within the scatter graph.

  • Under trendline options – select linear trendline and select “Display Equation on chart.”

  • The least-squares regression equation for the given set of Excel data is displayed on the chart.

Thus, one can calculate the least-squares regression equation for the Excel data set. Predictions and trend analyses one may make using the equation. Excel tools also provide detailed regression computations.

Advantages

  • The least-squares regression analysis method best suits prediction models and trend analysis. One may best use it in economics, finance, and stock markets, wherein the value of any future variable is predicted with the help of existing variables and the relationship between them.The least-squares method provides the closest relationship between the variables. The difference between the sums of squares of residuals to the line of best fit is minimal under this method.The computation mechanism is simple and easy to apply.

Disadvantages

  • The least-squares method establishes the closest relationship between a given set of variables. The computation mechanism is sensitive to the data, and in case of any outliers (exceptional data), results may affect majorly.This type of calculation is best suited for linear models. For nonlinear equations, applied more exhaustive computation mechanisms.

Conclusion

The least-squares method is one of the most popular prediction models and trend analysisTrend AnalysisTrend analysis is an analysis of the company’s trend by comparing its financial statements to analyze the market trend or analysis of the future based on past performance results, and it is an attempt to make the best decisions based on the results of the analysis done.read more methods. When calculated appropriately, it delivers the best results.

This article is a guide to Least Squares Regression Method and its definition. Here, we discuss the formula to calculate the least-squares regression line along with Excel examples. You can learn more from the following articles: –

  • Linear Regression ExamplesMultiple Regression Analysis FormulaANOVA in ExcelEWMA