Overfitting

AAA

DEFINITION of 'Overfitting'

A modeling error which occurs when a function is too closely fit to a limited set of data points. Overfitting the model generally takes the form of making an overly complex model to explain idiosyncrasies in the data under study. In reality, the data being studied often has some degree of error or random noise within it. Thus attempting to make the model conform too closely to slightly inaccurate data can infect the model with substantial errors and reduce its predictive power.

INVESTOPEDIA EXPLAINS 'Overfitting'

Financial professionals must always be aware of the dangers of overfitting a model based on limited data. For instance, a common problem is using computer algorithms to search extensive databases of historical market data in order to find patterns. Given enough study, it is often possible to develop elaborate theorems which appear to predict things such as returns in the stock market with close accuracy. However, when applied to data outside of the sample, such theorems may likely prove to be merely an overfitting of a model to what were in reality just chance occurrences. In all cases, it is important to test a model against data which is outside of the sample used to develop it.

RELATED TERMS
  1. Stochastic Modeling

    A method of financial modeling in which one or more variables ...
  2. Financial Modeling

    The process by which a firm constructs a financial representation ...
  3. Non-Sampling Error

    A statistical error caused by human error to which a specific ...
  4. Multiple Linear Regression - MLR

    A statistical technique that uses several explanatory variables ...
  5. Regression

    A statistical measure that attempts to determine the strength ...
  6. Altman Z-Score

    The output of a credit-strength test that gauges a publicly traded ...
RELATED FAQS
  1. What is the criteria for a simple random sample?

    Simple random sampling is the most basic form of sampling and can be a component of more precise, more complex sampling methods. ... Read Full Answer >>
  2. What are some examples of ways that sensitivity analysis can be used?

    Sensitivity analysis is an analysis method that is used to identify how much variations in the input values for a given variable ... Read Full Answer >>
  3. Why are some spin-offs taxable and some are tax-free?

    The manner in which a parent company structures the spinoff and divests itself of a subsidiary or division determines whether ... Read Full Answer >>
  4. How is the 80-20 rule (Pareto's Principle) used in macroeconomics?

    The 80-20 rule was first used in macroeconomics to describe the distribution of wealth in Italy in the early 20th century, ... Read Full Answer >>
  5. Which has performed better historically, the stock market or real estate?

    For the majority of U.S. history – or at least as far back as reliable information goes – housing prices have increased only ... Read Full Answer >>
  6. What are some of the uses of the coefficient of variation (COV)?

    In statistics, the coefficient of variation (COV) is a simple measure of relative event dispersion. It is equal to the ratio ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    Build A Model Portfolio With Style Investing

    This sophisticated approach will add flair to your returns.
  2. Fundamental Analysis

    Do-It-Yourself Analyst Predictions

    Regular investors can build their own financial models using the mosaic theory.
  3. Options & Futures

    Multivariate Models: The Monte Carlo Analysis

    This decision-making tool integrates the idea that every decision has an impact on overall risk.
  4. Professionals

    Style Matters In Financial Modeling

    If you're looking to get a job as an analyst, you'll need to know how to work it.
  5. Active Trading

    Introduction To Stationary And Non-Stationary Processes

    What to know about stationary and non-stationary processes before you try to model or forecast.
  6. Investing

    The Case For Stocks Today

    Last week, U.S. equities advanced with the S&P 500 Index notching new records. Investors are now getting nervous with rate and currency volatility spiking.
  7. Mutual Funds & ETFs

    Why You May Want To Be (And Stay) In Bonds

    Bonds are complicated, and it’s easy to feel intimidated or confused. Fortunately, you don’t need to be a numbers geek to be an informed investor.
  8. Fundamental Analysis

    Calculating the Herfindahl-Hirschman Index (HHI)

    The Herfindhal-Hirschman Index, (HHI) is a measure of market concentration and competition among market participants.
  9. Fundamental Analysis

    Calculating Net Interest Margin

    Net interest margin is a metric used to measure the effectiveness of a company’s investment decisions, particularly financial institutions.
  10. Investing

    What More Volatility Means For Momentum Stocks

    One byproduct of the recent tick higher in bond yields: a meaningful rise in volatility for both stocks and bonds.

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Productivity

    An economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in ...
  3. Variance

    The spread between numbers in a data set, measuring Variance is calculated by taking the differences between each number ...
  4. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as ...
  5. Rule Of 70

    A way to estimate the number of years it takes for a certain variable to double. The rule of 70 states that in order to estimate ...
  6. Risk Premium

    The return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is ...
Trading Center