How bad is Cholesky decomposition for OLS? I've heard that I should never use Cholesky decomposition for OLS as it's super unstable, so I thought I'd try a very simple example to see how bad it could be.
First let's set up the problem in R:
X <- rbind(c(1, 1), c(1.00001, 1))
kappa(t(X) %*% X)

The condition number is 160002098109! Oooh boy, coefficients will be off by at least a billion for sure!
y <- rnorm(2)
L <- chol(t(X) %*% X)
z <- solve(t(L), t(X) %*% y)

result <- data.frame(chol = solve(L, z), qr = coefficients(lm.fit(X, y, method = 'qr')))
result

        chol        qr
x1 -148230.9 -148231.0
x2  148231.9  148232.1

...almost no difference. What happened? If the condition number is so big that no method can handle it well, what is the range of condition numbers at which the Cholesky solution is in fact appreciably less stable than with QR decomposition?
 A: What you are seeing is exactly what one would expect. The condition number of your matrix $X$ is about $10^6$. Double precision floating point calculations give about 18 figures of accuracy so, in double precision, you would expect to get at most $18-6=12$ significant figures for the estimated coefficients from QR and at most $18-6-6=6$ significant figures from Cholesky, after allowing for accuracy lost due to conditioning.
(Cholesky loses twice the number of significant figures because forming $X^TX$ squares the condition number.)
Hence the coefficients from the two algorithms should start to differ in the 6th significant figure, which is exactly what you see. Your results show that for x2 the relative difference between the two algorithms is about
$$ 0.2 / 148232 = 1.35 \times 10^{-6},$$
which matches the condition number you started out with surprisingly well.
The condition number of $X$ is a reasonable guide to precision when the residuals are small. If we make sure that the exact coefficients are 1 and 1.00001 by
> y <- X %*% c(1,1.00001)

and rerun your calculation we get
> result
                 chol                qr
x1 0.9999833544961814 0.999999999968327
x2 1.0000266455870466 1.000010000031673

confirming that QR is in fact correct to 12 significant figures and Cholesky is correct to 6 significant figures.
The fitted values from Cholesky are generally more precise than the estimated coefficients. If the fitted values are more important to you than the coefficients, and that will often be so in highly collinear cases, then Cholesky is usually fine.
Cholesky is also about as good as QR when the residuals are very large, but this is the hardest case for both algorithms.
My PhD supervisor was Australia's foremost numerical analyst (Mike Osborne) and he used to say that Cholesky was not as bad as it's made out to be.
The full sensitivity analysis for Cholesky vs QR is given in Section 5.3.8 of Golub and Van Loan (1996), and is very much more complex than the simple calculation I used above. The sensitivity of Cholesky is roughly proportion to $\kappa + \rho \kappa^2$ where $\kappa$ is the condition number of $X$ and $\rho$ is a theoretical quantity that is almost impossible to compute in practice.
$\rho$ depends on the size of the residuals-- it is roughly proportional to but much smaller than the average squared residual.
The sensitivity of QR is somewhat better than Cholesky although not always as good as I have suggested above. Golub and Van Loan remark:

At the very minimum, this discussion should convince you how difficult it can be to choose the "right" algorithm!

Reference
Golub, GH, and Van Loan CF (1996). Matrix Computations. Johns Hopkins University Press, Baltimore.
