What is the 'Line Of Best Fit'
A line of best fit is a straight line drawn through the center of a group of data points plotted on a scatter plot. Scatter plots depict the results of gathering data on two variables. The line of best fit shows whether these two variables appear to be correlated and can be used to help identify trends occurring within the dataset.
BREAKING DOWN 'Line Of Best Fit'Analysts may use the line of best fit when determining a relationship between two variables where one variable is independent and one variable is being examined for dependency. The proposed dependent variable is listed on the vertical Y axis while the independent variable is shown on the horizontal X axis. An example of an independent variable commonly used in financial analysis is time with each interval representing a specific number of minutes, hours, days, months, or years. Dependent variables can include, but are not limited to, the price of an investment or asset, production rates or corporate profit levels.
Least Squares Method and Regression Analysis
A more precise method for determining the line of best fit is a mathematical calculation called the least squares method which is frequently used in computer-based data modeling. The least squares method looks to limit the deviations within a dataset when the line of best fit is created.
The line of best fit is used in regression analysis and is a key input in statistical calculations such as the sum of squares. It can also be used as a tool for analyzing investment risk or trading activity.
Examples of Potential Uses for a Line of Best Fit
Also referred to as a linear regression or a trend line, the line of best fit is a common tool for showing how two variables may be related. Examples of types of variables whose correlation, or lack thereof, could be shown with a scatter plot and line of best fit include the number of months someone has been unemployed and the size of their emergency fund, the number of years of education completed and the person’s annual salary or mortgage interest rates and the number of home sales.
In investing, the line of best fit is used in order to demonstrate any observed trends in hope of being able to predict future outcomes regarding the data point variable in use, such as whether a stock is exhibiting signs of an upward trend. This form of analysis can also be used to observe whether any chosen variables are dependent in nature and is often used to illustrate statistical or scientific data models.