Let’s Use Ridge Regression to Predict Time Series

Using Python to Predict Time Series With Ridge Regression

Sofien Kaabar, CFA

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Ridge regression is a regression technique that adds a penalty term to the traditional linear regression model, aiming to prevent overfitting by shrinking the coefficients of the predictors towards zero. This regularization helps to handle multicollinearity and stabilize the estimates, making the model more robust, especially when dealing with datasets with high dimensionality or highly correlated predictors.

Traditional linear regression techniques may struggle if the predictors are highly correlated or if there are many predictors relative to the sample size. Ridge regression, with its ability to handle multicollinearity and stabilize coefficient estimates, may offer a solution by providing more reliable predictions and better model performance on stationary time series data.

This article presents a simple way to create a Ridge regression model in Python to predict the returns of the S&P 500 index.

Introduction to Ridge Regression

Linear regression is a common method used to predict the relationship between independent variables (features) and a dependent variable (outcome). It works by fitting a straight line to the data points. However, in some cases, when we have a lot of features or when these features are highly correlated, traditional linear regression can lead to overfitting, which means the model might perform poorly on new data it hasn’t seen before.

This is where ridge regression comes in. Ridge regression is a technique that’s quite similar to linear regression, but with a twist. It adds a penalty term to the traditional linear regression equation, which helps to regularize the coefficients. Regularization is like adding a speed bump to the modeling process, preventing the model from becoming too complex and overfitting the data.

The penalty term in ridge regression is called the L2 penalty. It works by adding the squared sum of the coefficients to the traditional least squares cost function used in linear regression. This has the effect of shrinking the coefficients towards zero, but not exactly to zero unless they’re truly irrelevant. So, even if some…

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