medium · FRM Part 1 Quantitative Analysis
An analyst is evaluating a multifactor model and observes that adding three new macroeconomic variables causes the raw R^2 to increase from 0.65 to 0.67. However, the adjusted R^2 decreases.
Which of the following is the most accurate interpretation of this result?
- The total sum of squares (TSS) has decreased because the model has become more parsimonious.
- The new variables have introduced perfect multicollinearity, making the raw R^2 an unreliable measure of fit.
- The model's residual sum of squares (SSR) must have increased, indicating a poorer fit to the training data.
- The increase in raw R^2 is purely due to the reduction in the degrees of freedom rather than any true explanatory power of the new variables.
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