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LogoutAutocorrelation: The presence of correlation in error terms drastically reduces model’s accuracy. This usually occurs in time series models where the next instant is dependent on previous instant. If the error terms are correlated, the estimated standard errors tend to underestimate the true standard error.
If this happens, it causes confidence intervals and prediction intervals to be narrower. Narrower confidence interval means that a 95% confidence interval would have lesser probability than 0.95 that it would contain the actual value of coefficients. Let’s understand narrow prediction intervals with an example:
For example, the least square coefficient of X¹ is 15.02 and its standard error is 2.08 (without autocorrelation). But in presence of autocorrelation, the standard error reduces to 1.20. As a result, the prediction interval narrows down to (13.82, 16.22) from (12.94, 17.10).
Also, lower standard errors would cause the associated p-values to be lower than actual. This will make us incorrectly conclude a parameter to be statistically significant.
How to check: Look for Durbin – Watson (DW) statistic. It must lie between 0 and 4. If DW = 2, implies no autocorrelation, 0 < DW < 2 implies positive autocorrelation while 2 < DW < 4 indicates negative autocorrelation. Also, you can see residual vs time plot and look for the seasonal or correlated pattern in residual values.