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Lesson 2 of 6 6–9% of the exam

You are reading the 2026 curriculum (exams up to November 2026). Sitting in February 2027 or later? Go to the 2027 Quantitative Methods guide.

The four regression assumptions and what residual plots reveal

The model assumes a linear relation, constant error variance (homoskedasticity), independent errors and normally distributed errors. Plot the residuals: a curve means non-linearity, a fan means heteroskedasticity, runs or waves over time mean dependent errors, and a lopsided histogram or an extreme point means non-normality.

6 min cram, 30 min full read. Based on the 2026 CFA® Program Level I curriculum, Quantitative Methods, Learning Module 10. This is the 2026 version of the lesson. Sitting in February 2027 or later? Read the updated 2027 version.

Tailor this to you: take the self-assessment

Before this: The regression line: slope, intercept and least squares

On the exam

  • Explain the assumptions underlying the simple linear regression model, and describe how residuals and residual plots indicate if these assumptions may have been violated

Explain the assumptions of simple linear regression and describe how residuals and residual plots reveal violations. Expect a described plot and a question on which assumption is broken. A fan is heteroskedasticity, not non-linearity, and the normality assumption is about the errors.

How deeply to learn each part
Know the idea
Understand it in general. It frames other topics, but you will not calculate with it.
Use it
Understand it well enough to solve a question with it. Recognize when it applies.
Memorize
Learn it by heart. The exam will not give it to you.

You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.

You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.

Cram mode: the one-screen version of this lesson. Switch to Full for the explanations, worked examples and interactives.

Why do the assumptions matter?

Least squares will draw a line through any cloud of points. The tests and prediction intervals in the next lessons are only reliable if four assumptions hold. You cannot see the errors themselves, but you can see their sample estimates, the residuals. A residual plot shows the residuals against X (or against time). A healthy plot looks like random scatter in a level band around zero. Any shape is a warning.

What are the four assumptions?

AssumptionMeaningResidual plot when brokenExample
linearity Y is a linear function of X in the parametersU-shape or archRevenue that compounds over time, fitted with a straight line
homoskedasticity The error variance is the same for every observationFan or funnel, or a step change between two regimesReturn spreads that widened after a rate-policy change
independence of errors Errors are uncorrelated with each otherPatterns over time: runs of positives then negatives, seasonal wavesQuarterly sales with a holiday-quarter spike
normality of errors The errors are normally distributedSkewed or fat-tailed residual histogram, extreme pointsOne data-entry error ten times larger than the rest
Assumptions and how residual plots expose a breach
Simple linear regression assumptionscheck them with the residuals
  • Linearity Memorize Y is a linear function of X in the parameters
    • Broken: curve or arch in the residuals fix: transform the variables
  • Homoskedasticity Memorize error variance is the same for every observation
    • Broken (heteroskedasticity): fan, funnel or step change fix: split the sample or transform
  • Independence of errors Memorize one error tells you nothing about the next
    • Broken (serial correlation): runs, waves, seasonal pattern common in time series
  • Normality of errors Memorize matters most in small samples
    • Broken: skewed or fat-tailed histogram, outliers check for data errors first

Two more points complete the list. The independent variable is assumed not to be random (or at least uncorrelated with the error), and its values must vary, or there is nothing to learn a slope from.

InteractiveWhat do the residuals say? Well-behaved

Try this 0 of 3

  • Diagnose all five data sets correctly.
  • Load “One bad entry” and drag the ringed point down until R² is above 0.90.
  • Load “Curved” and compare its R² with the well-behaved set.

Well-behaved data: least-squares line Ŷ = 3.61 + 0.729X, R² 0.931. No assumption looks broken: the residuals are random noise in a level band around zero, with no curve, fan or rhythm. Residuals should look like random noise in a level band; any shape is a warning.

Data and the fitted line

06121824Y0481216X
  • Least-squares line

Residuals against X

−4−2024Residual Y − Ŷ0481216X

A steady relation with random noise. Look at the residual plot, then pick the assumption that looks broken.

Slope b₁0.729
R²0.931
Largest residual1.94
Diagnosed right0 of 5
Data set
Load a data set
Your diagnosis
Which assumption looks broken?
Show working

Least-squares line: Ŷ = 3.61 + 0.729X (n = 16). R² = SSR ÷ SST = 180.46 ÷ 193.76 = 0.931.

Residuals Y − Ŷ in X order: 1.56, −0.86, −0.29, 0.28, −1.05, −0.08, −0.01, −1.94, 1.34, 0.91, −0.42, 0.15, 1.02, 0.19, 0.26, −1.06.

Standard error of estimate SEE = √(SSE ÷ (n − 2)) = √(13.30 ÷ 14) = 0.975.

Read the residual plot, not R²: a curve means non-linearity, a fan means heteroskedasticity, a rhythm over time means dependent errors, and a few huge misses mean non-normal errors.

Residuals should look like random noise in a level band; any shape is a warning.

What does each violation look like?

Non-linearity. If the true relation curves, a straight line is too high in the middle and too low at the ends (or the reverse). The residuals trace a U or an arch. A company whose revenue grows 15% a year looks like a smooth upward bend, so a straight line leaves a bow in the residuals.

Heteroskedasticity. The spread of the residuals changes with X, which is heteroskedasticity . A fan opening to the right means larger X goes with larger errors. The word describes unequal variance, so the opposite, constant variance, is homoskedasticity. The same signal appears when two regime periods are pooled: the residuals are small in the early years and large in the later years because the relationship itself changed. Estimating each regime separately fits better than one pooled line.

Dependent errors. Plot the residuals in time order. Long runs of positives followed by negatives, or a repeating seasonal pattern, show that today’s error predicts tomorrow’s. This is serial correlation . It is the typical problem of regressions on time series, and it makes the usual standard errors unreliable.

Non-normal errors. A histogram of the residuals that is lopsided or has fat tails points to non-normality. Normality matters most in small samples, because the t and F tests lean on it. In large samples the central limit theorem rescues the coefficient tests.

How do outliers distort a regression?

An outlier is an observation far from the rest. Least squares squares each miss, so the line tilts toward the outlier. It can inflate R² (one point far up and to the right makes the cloud look like a strong line) or flatten a real slope.

Exam tip When a question describes a shape, name the shape first (curve, fan, wave, lopsided), then match it to the assumption. Never pick “linearity” for a fan.

Go deeper Regime changes: when one line is really two

Suppose a bond-yield relationship held before a central bank changed policy and held differently after. Pooling both periods gives a single line that fits neither regime and residuals with a visible step in spread. The sample comes from more than one distribution. The remedy is to estimate separate regressions for each regime, or to model the change explicitly, which needs more than one independent variable (multiple regression, covered at Level II).

Go deeper What can you do about a violation?

At this level, three responses are enough. Transform the variables, for example with logs, to straighten a curve or steady a widening spread (lesson 6). Split the sample where the relation changed. Or add more explanatory variables, which takes you into multiple regression. Do not simply drop a point because it hurts the fit: check first whether it is a data error.

Memorize this

MemorizeAssumption, tell-tale, example

AssumptionResidual plot when brokenTypical cause
LinearityU-shape or archcompounding series fitted with a straight line
Homoskedasticityfan or funnel; step change in spreadspread widens as X grows; two regimes pooled
Independenceruns of + then −, seasonal wavestime series with trends or seasonality
Normalityskewed or fat-tailed histogram, outliersa data-entry error, extreme events

Memory hook Four assumptions, four shapes: curve, fan, wave, lopsided. Good residuals look like static on a TV: a level band with no shape.

Know it cold The assumptions are about the errors and the model (linear in the parameters), not about X being normal. A high R² does not prove them.

Assumptions and how residual plots expose a breach
Simple linear regression assumptionscheck them with the residuals
  • Linearity Memorize Y is a linear function of X in the parameters
    • Broken: curve or arch in the residuals fix: transform the variables
  • Homoskedasticity Memorize error variance is the same for every observation
    • Broken (heteroskedasticity): fan, funnel or step change fix: split the sample or transform
  • Independence of errors Memorize one error tells you nothing about the next
    • Broken (serial correlation): runs, waves, seasonal pattern common in time series
  • Normality of errors Memorize matters most in small samples
    • Broken: skewed or fat-tailed histogram, outliers check for data errors first

How it is asked

  1. Residuals fan out

    A residual plot shows residuals spreading wider as X increases. Which assumption?

    Homoskedasticity is violated (heteroskedasticity). Trap: linearity.

  2. Pattern over time

    Quarterly sales residuals are positive every fourth quarter and negative otherwise.

    Errors are not independent (serial correlation, a seasonal pattern).

  3. Who must be normal?

    The normality assumption applies to which variable?

    The error term (residuals), not X and not the levels of Y.

  4. A good fit hiding a problem

    R² is 0.92 but one extreme point drives it; without it R² is 0.31.

    Outliers can create a misleadingly good fit. High R² does not confirm the assumptions.

Exam traps

  • Calling a fan shape non-linearity: a fan is heteroskedasticity, a curve is non-linearity.
  • Thinking the independent variable must be normally distributed. The assumption is about the errors.
  • Assuming a high R² proves the assumptions hold. One outlier can inflate R² and tilt the line.
  • Forgetting that pooling two regimes into one regression can make the residual spread jump between periods.

Checkpoint

4 exam-style questions. About 90 seconds each.

  1. 1A residual plot shows residuals that spread wider as X increases. This most likely indicates a violation of:

  2. 2Residuals from a regression on quarterly sales are positive every fourth quarter and negative in the others. The assumption most likely violated is:

  3. 3The normality assumption in simple linear regression applies to the:

  4. 4A regression has R² = 0.92, but removing one extreme observation drops R² to 0.31. This best illustrates that:

Key takeaways

  • Four assumptions: linearity, homoskedasticity, independent errors, normal errors.
  • Read the residual plot: curve, fan, wave or lopsided histogram each point to one assumption.
  • Outliers can create a misleadingly good fit; R² alone never validates a model.

Questions about this lesson?

Where this comes back

Questions candidates ask

What are the assumptions of simple linear regression?

The relationship is linear in the parameters, the error variance is constant (homoskedasticity), the errors are independent of each other, and the errors are normally distributed. The independent variable is also assumed not to be random, or at least uncorrelated with the errors, and to take varying values.

What does heteroskedasticity look like on a residual plot?

A fan or funnel: residuals are tightly bunched at one end of the X range and spread out at the other. A step change in spread between two periods, such as before and after a policy shift, is also heteroskedasticity.

How do outliers affect a regression?

Least squares squares the misses, so an extreme point pulls the line toward it. It can change the slope and intercept sharply and can inflate or deflate R². Check whether it is a data error or a genuine observation before deciding what to do.

Spotted an error? Tell us and we will fix it.

  1. The regression line: slope, intercept and least squares
  2. The four regression assumptions and what residual plots reveal
  3. Goodness of fit and testing the regression coefficients
  4. The ANOVA table and the standard error of estimate
  5. Predicting Y and building a prediction interval
  6. Functional forms: log-lin, lin-log and log-log models

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