Analysis of Variance (ANOVA)

One-way ANOVA | When and How to Use It (With Examples)

ANOVA, which stands for Analysis of Variance, is a statistical test used to analyze the difference
between the means of more than two groups. Analysis of variance is a family of statistical
methods used to compare the means of two or more groups by analyzing variance. Specifically,
ANOVA compares the amount of variation between the group means to the amount of variation
within each group.

A one-way ANOVA uses one independent variable, while a two-way ANOVA uses two
independent variables.

One-way ANOVA exampleAs a crop researcher, you want to test the effect of three different
fertilizer mixtures on crop yield. You can use a one-way ANOVA to find out if there is a difference
in crop yields between the three groups.

When to use a one-way ANOVA

Use a one-way ANOVA when you have collected data about one categorical independent
variable and one quantitative dependent variable. The independent variable should have at
least three levels (i.e. at least three different groups or categories).

ANOVA tells you if the dependent variable changes according to the level of the independent
variable. For example:

 Your independent variable is social media use, and you assign groups to low, medium,
and high levels of social media use to find out if there is a difference in hours of sleep
per night.

 Your independent variable is brand of soda, and you collect data on Coke, Pepsi, Sprite,
and Fanta to find out if there is a difference in the price per 100ml.

 You independent variable is type of fertilizer, and you treat crop fields with
mixtures 1, 2 and 3 to find out if there is a difference in crop yield.

The null hypothesis (H0) of ANOVA is that there is no difference among group means. The
alternative hypothesis (Ha) is that at least one group differs significantly from the overall mean
of the dependent variable.
If you only want to compare two groups, use a t test instead.

How does an ANOVA test work?

ANOVA determines whether the groups created by the levels of the independent variable are
statistically different by calculating whether the means of the treatment levels are different
from the overall mean of the dependent variable.

If any of the group means is significantly different from the overall mean, then the null
hypothesis is rejected.

ANOVA uses the F test for statistical significance. This allows for comparison of multiple means
at once, because the error is calculated for the whole set of comparisons rather than for each
individual two-way comparison (which would happen with a t test).

The F test compares the variance in each group mean from the overall group variance. If the
variance within groups is smaller than the variance between groups, the F test will find a
higher F value, and therefore a higher likelihood that the difference observed is real and not
due to chance.

Cheat Sheet on Common Statistical Tests in Finance and Investing

Test Purpose When To Use Applications in

Finance/Investing

ANOVA Compare the means of three • Data is normally • Comparing financial

or more groups distributed performance across different
sectors or investment
strategies

Chi-Square Test for association between • Data is categorical • Analyzing customer

Test two categorical variables (e.g., investment demographics and portfolio
(can't be measured on a choices, market allocations
numerical scale) segments)

One-Sample Compare a sample mean to a • Data is normally • Comparing actual vs.

T-Test known population mean distributed or the expected returns
sample size is large
Cheat Sheet on Common Statistical Tests in Finance and Investing

Paired T-Test Compare means of two • Data is normally • Evaluating if a financial

related samples (e.g., before distributed or the change has been effective
and after measurements) sample size is large

T-Test Compare the means of two • Data is normally • Comparing the

groups distributed or the performance of two
sample size is large investment strategies

Z-Test Compare a sample mean to a • Data is normally • Testing hypotheses about

known population mean distributed and market averages
population standard
deviation is known

Correlation Measure the strength and • Data is continuous • Assessing risk and return of
direction of a linear assets, portfolio
relationship between two diversification
variables

F-Test Compare variances of two or • Data is normally • Testing the equality of

more groups distributed variances in stock returns and
portfolio performance

Regression Predict the value of one • Data is continuous • Modeling stock prices •
variable based on the value Predicting future returns
of another variable

What ANOVA Reveals

ANOVA splits an observed aggregate variability inside a data set into two parts: systematic
factors and random factors. The systematic factors influence the given data set, while the
random factors do not.

The ANOVA test lets you compare more than two groups simultaneously to determine whether
a relationship exists between them. The result of the ANOVA formula, the F statistic or F-ratio,
allows you to analyze several data groups to assess the variability between samples and within
samples.

If no real difference exists between the tested groups, called the null hypothesis, the result of
the ANOVA's F-ratio statistic will be close to one. The distribution of all possible values of the F
statistic is the F-distribution. This is a group of distribution functions with two characteristic
numbers, called the numerator degrees of freedom and the denominator degrees of freedom.

One-Way vs. Two-Way ANOVA

One-Way vs. Two-Way ANOVA

One-Way ANOVA

 Uses one independent variable or factor

 Assesses the impact of a single categorical variable on a continuous dependent variable,

identifying significant differences among group means

 Does not account for interactions

Two-Way ANOVA

 Uses two independent variables or factors

 Used to not only understand the individual effects of two different factors but also how
the combination of these two factors influences the outcome

 Can test for interactions between factors

A one-way ANOVA evaluates the impact of a single factor on a sole response variable. It
determines whether all the samples are the same. The one-way ANOVA is used to determine
whether there are any statistically significant differences between the means of three or more
independent groups.

A two-way ANOVA is an extension of the one-way ANOVA. With a one-way, there is one
independent variable affecting a dependent variable. With a two-way ANOVA, there are two
independent variables. For example, a two-way ANOVA allows a company to compare worker
productivity based on two independent variables, such as salary and skill set. It's utilized to see
the interaction between the two factors and test the effect of two factors simultaneously.

ANOVA Example

Suppose you want to assess the performance of different investment portfolios across various
market conditions. The goal is to determine which portfolio strategy performs best under what
conditions.
You have three portfolio strategies:

1. Technology portfolio (tech stocks): High-risk, high return

2. Balanced portfolio (stocks and bonds): Moderate-risk, moderate return

3. Fixed-income portfolio (bonds and money market instruments): Low-risk, low return

You also want to check against two market conditions:

1. A bull market

2. A bear market

A one-way ANOVA could give a broad overview of portfolio strategy performance, while a two-
way ANOVA adds a deeper understanding by including the varying market conditions.

One-Way ANOVA

A one-way ANOVA could be used to initially analyze the performance differences among the
three different portfolios without considering the impact of market conditions. The independent
variable would be the type of investment portfolio, and the dependent variable would be the
returns generated.

You would group the returns of the technology, balanced, and fixed-income portfolios for a
preset period and compare the mean returns of the three portfolios to determine if there are
statistically significant differences. This would help determine whether different investment
strategies result in different returns, but it would not account for how different market
conditions might influence these returns.

Two-Way ANOVA

Meanwhile, a two-way ANOVA would be more appropriate for analyzing both the effects of the
investment portfolio and the market conditions, as well as any interaction between these two
factors on the returns.

Techniques/Steps to use ANOVA/Here's a step-by-step guide on how to use it:

1. Define the Hypotheses:

 Null Hypothesis (H0): There is no significant difference between the group means.

 Alternative Hypothesis (H1): There is a significant difference between at least two group
means.
2. Gather and Organize Data:

 Ensure your data is suitable for ANOVA (e.g., continuous dependent variable and
categorical independent variable(s)).

 Organize your data into groups corresponding to the levels of your independent
variable(s).

3. Choose the Appropriate ANOVA Type:

 One-Way ANOVA:

Used when you have one independent variable with multiple levels, and one dependent
variable.

 Two-Way ANOVA:

Used when you have two or more independent variables and one dependent variable, allowing
you to explore main effects and interactions.

4. Perform the ANOVA Test:

 Software:

Use statistical software like SPSS, R, or Excel (with the Data Analysis ToolPak) to perform the
ANOVA calculation.

 Manual Calculation:

ANOVA involves calculating sums of squares (SS), degrees of freedom (df), and mean squares
(MS) for between-group and within-group variation, leading to an F-statistic.

5. Interpret the Results:

 F-statistic:

The F-statistic compares the variation between groups to the variation within groups.

 P-value:

The p-value is the probability of observing the obtained results (or more extreme results) if the
null hypothesis is true.

 Decision:

If the p-value is less than the significance level (alpha, usually 0.05), you reject the null
hypothesis and conclude that there is a significant difference between the group means.

6. Post-Hoc Tests (if needed):

  If the overall ANOVA indicates a significant difference, post-hoc tests (like Tukey's HSD)
can be used to identify which specific pairs of groups are significantly different.

In simpler terms: ANOVA helps you determine if the average values of a variable are different
across different groups. It compares the variance between the groups to the variance within the
groups to make this determination.