Omitted correlated information
Question
A linear return model omits a variable correlated with both the included signal and the target. What is the interpretation risk?
Short answer
If the omitted variable belongs in the conditional mean and is correlated with the included signal, its effect can be absorbed into the signal coefficient. The coefficient then need not identify the signal's causal effect. Predictive performance may still be useful within a stable distribution, but can fail when the correlation structure changes. Distinguish causal identification from forecasting and test stability across plausible regimes.
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Open the worked solutionLessons behind this question
- Ridge, Lasso, and Elastic Net
- The Normal Equations: Closed-Form Least Squares
- Covariance and Correlation
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