In ordinary least squares (OLS) regression, for given $X: \mathbb{R}^{p} \rightarrow \mathbb{R}^{n}$ and $y \in \mathbb{R}^{n}$, we minimize over $\beta \in \mathbb{R}^{p}$ the sum of squared residuals

\[\newcommand{\norm}[1]{\left\lVert#1\right\rVert} S(\beta) = \norm{ y - X\beta }_{2}^{2}\]This blog post illustrates the problem (Figure 1) of using OLS method to estimate the unknown parameters $\beta$ in the case of highly correlated regressors on a simple example using R.

Suppose we have a model

\[y \sim \beta_{0} + \beta_{1} x_{1} + \beta_{2} x_{2}\]where

\[\beta_{0} = 3, \quad \beta_{1} = \beta_{2} = 1.\]Let the sample contain 100 elements:

```
n <- 100
```

and letâ€™s introduce some highly correlated regressors:

```
set.seed(42)
x1 <- rnorm(n)
x2 <- rnorm(n, mean = x1, sd = 0.01)
```

with correlation coefficient almost 1:

```
cor(x1, x2)
[1] 0.999962365268769
```

We can run the OLS method 1000 times to get a sense of the effect of highly correlated regressors:

```
x <- as.matrix(cbind(intr = 1, x1, x2))
nsim <- 1000
betas <- sapply(1:nsim, function(i) {
y <- rnorm(n, mean = 3 + x1 + x2, sd = 1)
xx <- solve(t(x) %*% x)
beta.ols <- as.vector(xx %*% t(x) %*% y)
return(beta.ols)
})
```

The estimator for $\beta$, obtained by the OLS method, is still unbiased

```
round(apply(betas, 1, mean), 3)
[1] 2.996 1.006 0.993
```

But the variance is large

```
round(apply(betas, 1, sd), 3)
[1] 0.101 11.110 11.103
```

The estimated coefficients can be very large, some can even have the wrong sign:

```
round(betas[, 1], 3)
[1] 3.002 -7.673 9.529
```

The problem can be seen by drawing a contour plot (shown in Figure 1) of the objective function $S(\beta)$:

```
ssr <- function(b) {
return(sum((y - x %*% b)^2))
}
xlen <- 100
ylen <- 100
xgrid <- seq(-10.1, 10.1, length.out = xlen)
ygrid <- seq(-10.1, 10.1, length.out = ylen)
zvals <- matrix(NA, ncol = xlen, nrow = ylen)
for (i in 1:xlen) {
for (j in 1:ylen) {
zvals[i, j] <- ssr(c(3, xgrid[i], ygrid[j]))
}
}
contour(x = xgrid, y = ygrid, z = zvals,
levels = c(1e3, 3e3, 6e3, 1e4))
```

As the correlation between regressors increases, matrix $X$ becomes nearly singular and OLS method becomes unstable. In the limit

\[|corr(x_{i}, x_{j})| \rightarrow 1\]the dimension of the column space decreases

\[\text{rank}(X) < p.\]The objective function $S(\beta)$ is no longer strictly convex, and there are infinitely many solutions of OLS.

Intuitively, we would like to estimate the coefficient $\beta_{1}$ as the influence of $x_{1}$ on $y$ without the influence of $x_{2}$. Since the regressors $x_{1}$ and $x_{2}$ are highly correlated, they vary together and the coefficient $\beta_{1}$ is difficult to estimate. The OLS method does not accomplish this, as it only minimizes the sum of squared residuals, i.e. the objective function $S(\beta)$.

## Why does this happen?

In general, we have a linear model

\begin{equation} \label{eq: model} y = X \beta + \epsilon \end{equation}

and let for errors $\epsilon$ hold the assumption (Gaussâ€“Markov):

\[\mathbb{E}[\epsilon \epsilon^{T}] = \sigma^{2} I.\]The estimator according to the OLS method is

\begin{equation} \label{eq: betahat} \hat{\beta} = (X^{T}X)^{-1} X^{T} y. \end{equation}

From \ref{eq: model} and \ref{eq: betahat}, we get

\[\hat{\beta} - \beta = (X^{T}X)^{-1} X^{T} \epsilon\]Therefore, the covariance matrix for $\hat{\beta}$ is

\[\begin{align} \mathbb{E}[(\hat{\beta} - \beta) (\hat{\beta} - \beta)^{T}] \nonumber &= \mathbb{E}[\left((X^{T}X)^{-1} X^{T} \epsilon\right) \left((X^{T}X)^{-1} X^{T} \epsilon\right)^{T}] \nonumber \\[1em] &= \mathbb{E}[(X^{T}X)^{-1} X^{T} \epsilon \epsilon^{T} X (X^{T}X)^{-1}] \nonumber \\[1em] &= (X^{T}X)^{-1} X^{T} \mathbb{E}[\epsilon \epsilon^{T}] X (X^{T}X)^{-1} \nonumber \\[1em] &= \sigma^{2} (X^{T}X)^{-1} \label{eq: variance} \end{align}\]In the derivation, we took into account that the matrix $X^{T}X$ is symmetric and assumed that it is not stochastic and it is independent of $\epsilon$. The variance for the coefficient $\hat{\beta}_{k}$ is the $(k, k)$-th element of the covariance matrix.

The average distance between the estimator $\hat{\beta}$ and the actual $\beta$ is

\[\begin{align} \mathbb{E}[(\hat{\beta} - \beta)^{T} (\hat{\beta} - \beta)] \nonumber &= \mathbb{E}[((X^{T}X)^{-1} X^{T} \epsilon)^{T} ((X^{T}X)^{-1} X^{T} \epsilon)] \nonumber \\[1em] &= \mathbb{E}[\epsilon^{T} X (X^{T}X)^{-1} (X^{T}X)^{-1} X^{T} \epsilon] \nonumber \\[1em] &= \mathbb{E}[\text{tr}(\epsilon^{T} X (X^{T}X)^{-1} (X^{T}X)^{-1} X^{T} \epsilon)] \nonumber \\[1em] &= \mathbb{E}[\text{tr}(\epsilon \epsilon^{T} X (X^{T}X)^{-1} (X^{T}X)^{-1} X^{T} )] \nonumber \\[1em] &= \sigma^{2} \text{tr}( X (X^{T}X)^{-1} (X^{T}X)^{-1} X^{T} )] \nonumber \\[1em] &= \sigma^{2} \text{tr}( X^{T} X (X^{T}X)^{-1} (X^{T}X)^{-1})] \nonumber \\[1em] &= \sigma^{2} \text{tr}((X^{T}X)^{-1}) \label{eq: distance} \end{align}\]In the derivation, we used that the distance is a scalar, so its expected value will be equal to its trace. We then used the fact that the trace is invariant with respect to cyclic permutations:

\[\text{tr}(ABCD) = \text{tr}(DABC).\]From \ref{eq: variance} and \ref{eq: distance}, we see that both the variance of the estimator and the distance of the estimator from the actual $\beta$ depend on the matrix $(X^{T}X)^{-1}$.

The reason why the variance of the estimator and the distance of the estimator from the actual $\beta$ become large, can be shown conveniently using singular value decomposition. Let

\[X = U \Sigma V^{T}\]be the singular value decomposition of $X$ where $\Sigma$ contains all the singular values:

\[\sigma_{1} \geq \sigma_{2} \geq \dots \geq \sigma_{p} > 0.\]Then

\[\begin{align} (X^{T}X)^{-1} &= (V \Sigma^{T} \Sigma V^{T})^{-1} \nonumber \\[1em] &= (V^{T})^{-1} (\Sigma^{T} \Sigma)^{-1} V^{-1} \nonumber \\[1em] &= V (\Sigma^{T} \Sigma)^{-1} V^{T} \nonumber \\[1em] &= \sum_{j = 1}^{p} \frac{1}{\sigma_{j}^{2}} v_{j} v_{j}^{T} \label{eq: svd} \end{align}\]In the limit

\[| corr(x_{i}, x_{j}) | \rightarrow 1\]matrix $X$ becomes singular and the smallest singular value vanishes:

\[\sigma_{p} \rightarrow 0\]and from \ref{eq: svd}:

\[(X^{T}X)^{-1} \rightarrow \infty\]Therefore, from \ref{eq: variance} and \ref{eq: distance}, both the variance of the $\hat{\beta}$ and the distance of $\hat{\beta}$ to the actual $\beta$ go to infinity as \(| corr(x_{i}, x_{j}) | \rightarrow 1.\)