## What is an 'Error Term'

An error term is a variable in a statistical or mathematical model, which is created when the model does not fully represent the actual relationship between the independent variables and the dependent variables. As a result of this incomplete relationship, the error term is the amount at which the equation may differ during empirical analysis. The error term is also known as the residual, disturbance or remainder term.

Next Up

## BREAKING DOWN 'Error Term'

An error term represents the margin of error within a statistical model, referring to the sum of the deviations within the regression line, that provides an explanation for the difference between the results of the model and actually observed results. The regression line is used as a point of analysis when attempting to determine the correlation between one independent variable and one dependent variable.

The error term essentially means that the model is not completely accurate and results in differing results during real-world applications. For example, assume there is a multiple linear regression function that takes the form:

When the actual Y differs from the Y in the model during an empirical test, then the error term does not equal 0, which means there are other factors that influence Y.

Within a linear regression model that is tracking a stock’s price over time, the error term is the difference between the expected price at a particular time and the price that was actually observed. In instances where the price is exactly what was anticipated at a particular time, it will fall on the trend line and the error term is zero.

Points that do not fall directly on the trend line exhibit the fact that the dependent variable, in this case the price, is influenced by more than just the independent variable, representing the passage of time. The error term stands for any influence being exerted on the price variable, such as changes in market sentiment.

The two data points with the greatest distance from the trend line should be an equal distance from the trend line, representing the largest margin of error.

## Linear Regression, Error Term and Stock Analysis

Linear regression is a form of analysis that relates to current trends experienced by a particular security or index by providing a relationship between a dependent and independent variable, such as the price of a security and the passage of time, resulting in a trend line that can be used as a predictive model.

A linear regression exhibits less delay than that experienced with a moving average, as the line is fit to the data points instead of based on the averages within the data. This allows the line to change more quickly and dramatically than a line based on numerical averaging of the available data points.

RELATED TERMS
1. ### Regression

A statistical measure that attempts to determine the strength ...
2. ### Least Squares Method

The least squares method is a statistical technique to determine ...
3. ### Tracking Error

Tracking error tells the difference between the performance of ...
4. ### Line Of Best Fit

A straight line drawn through the center of a group of data points ...
5. ### Error Of Principle

An error of principle is an accounting mistake in which an entry ...
6. ### Negative Correlation

A perfect negative correlation is a relationship between two ...
Related Articles
1. Investing

### Regression Basics For Business Analysis

This tool is easy to use and can provide valuable information on financial analysis and forecasting. Find out how.
2. Investing

### What's a Sensitivity Analysis?

Sensitivity analysis is used in financial modeling to determine how one variable (the target variable) may be affected by changes in another variable (the input variable).

### When Is A Bull Market Not A Bull Market?

During some bull or bear moves in the stock markets, investors will be going with the trend, but day traders may find they cannot.
4. Investing

### Stock and Flow Variables Explained: A Closer Look at Apple

The difference between stock and flow variables is an essential concept in finance and economics. We illustrate with financial statements from Apple Inc.

### Calculating (Small) Company Credit Risk

Determining creditworthiness of smaller and medium-sized corporations isn't as easy as for larger companies, but these tips can help.
6. Investing

### ETF Tracking Errors: Protect Your Returns

Tracking errors tend to be small, but they can still adversely affect your returns. Learn how to protect against them.
7. Managing Wealth

### Is Your Portfolio Beating Its Benchmark?

Compare portfolio manager performance using the information ratio.

### How Do Companies Forecast Oil Prices?

Read about the different forecasting methods that businesses use to predict future crude oil prices, and why it's so difficult to guess correctly.
RELATED FAQS
1. ### What is the difference between linear regression and multiple regression?

Learn the difference between linear regression and multiple regression and how multiple regression encompasses not only linear ... Read Answer >>
2. ### Is tracking error a significant measure for determining ex-post risk?

Before we answer your question, let's first define tracking error and ex-post risk. Tracking error refers to the amount by ... Read Answer >>
3. ### How can you calculate correlation using Excel?

Find out how to calculate the Pearson correlation coefficient between two data arrays in Microsoft Excel through the CORREL ... Read Answer >>
Hot Definitions
1. ### Gross Margin

A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
2. ### Inflation

Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
3. ### Discount Rate

Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
4. ### Economies of Scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
5. ### Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
6. ### Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...