DEFINITION of 'Information Coefficient - IC'

The information coefficient (IC) is a measure used to evaluate the skill an investment analyst. The IC shows how closely the analyst's financial forecasts match actual financial results. The IC can range from 1 to -1, with -1 indicating the analyst's forecasts bear no relation to the actual results, and 1 indicating that the analyst's forecasts perfectly matched actual results.

The formula for the IC is:

IC = (2 * proportion correct) - 1, where "proportion correct" is the proportion of predictions made correctly by the analyst.

So, for example, if an analyst made two predictions and got two right, the IC would be (2 * 1.0) - 1 = 1.

If an analyst's predictions were half right, then (2 * 0.5) -1 = 0

If none of the predictions were right, then (2 * 0) -1 = -1

BREAKING DOWN 'Information Coefficient - IC'

An information coefficient (IC) score near +1 indicates that the analyst has great skill in forecasting. But, in reality, if the definition of "correct" is that the analyst's prediction matched the direction (up or down) of actual results, then the odds of getting the forecast right are 50/50. So even an analyst with no skill whatsoever could be expected to have an IC of around 0, meaning that half of the forecasts were right and half were wrong. A score close to 0 reveals that the analyst's forecasting skills are no better than results that could be achieved by chance, suggesting that ICs approaching -1 are rare.

The IC is not to be confused with the Information Ratio (IR). The IR is a measure of an investment manager's skill, comparing a manager's excess returns to the amount of risk taken.

The IC and the IR are components of the Fundamental Law of Active Management, which states that a manager's performance (IR) depends on skill level (IC) and its breadth, or how often it is used.

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