Overfitting

A A A

DEFINITION

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

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. Regression

    A statistical measure that attempts to determine the strength of the relationship ...
  2. Financial Modeling

    The process by which a firm constructs a financial representation of some, or ...
  3. Non-Sampling Error

    A statistical error caused by human error to which a specific statistical analysis ...
  4. Stochastic Modeling

    A method of financial modeling in which one or more variables within the model ...
  5. Multiple Linear Regression - MLR

    A statistical technique that uses several explanatory variables to predict the ...
  6. Compound Annual Growth Rate - CAGR

    The year-over-year growth rate of an investment over a specified period of time. ...
  7. Bidder

    The party offering to buy an asset from a seller at a specific price. A bidder ...
  8. Mean-Variance Analysis

    The process of weighing risk against expected return. Mean variance analysis ...
  9. Cash-And-Carry Trade

    A trading strategy in which an investor buys a long position in a security or ...
  10. Registration Right

    A right which entitles an investor who owns restricted stock the ability to ...
Related Articles
  1. Build A Model Portfolio With Style Investing
    Mutual Funds & ETFs

    Build A Model Portfolio With Style Investing

  2. Do-It-Yourself Analyst Predictions
    Fundamental Analysis

    Do-It-Yourself Analyst Predictions

  3. Style Matters In Financial Modeling
    Professionals

    Style Matters In Financial Modeling

  4. Introduction To Stationary And Non-Stationary ...
    Active Trading

    Introduction To Stationary And Non-Stationary ...

  5. Multivariate Models: The Monte Carlo ...
    Options & Futures

    Multivariate Models: The Monte Carlo ...

  6. Top Companies Trading On The Toronto ...
    Investing Basics

    Top Companies Trading On The Toronto ...

  7. During what time does after-hours trading ...
    Investing Basics

    During what time does after-hours trading ...

  8. Why does after-hours trading (AHT) exist?
    Investing Basics

    Why does after-hours trading (AHT) exist?

  9. How Nasdaq Continues To Innovate
    Stock Analysis

    How Nasdaq Continues To Innovate

  10. How A Company Files With The SEC
    Investing Basics

    How A Company Files With The SEC

comments powered by Disqus
Hot Definitions
  1. Genuine Progress Indicator - GPI

    A metric used to measure the economic growth of a country. It is often considered as a replacement to the more well known gross domestic product (GDP) economic indicator. The GPI indicator takes everything the GDP uses into account, but also adds other figures that represent the cost of the negative effects related to economic activity (such as the cost of crime, cost of ozone depletion and cost of resource depletion, among others).
  2. Accelerated Share Repurchase - ASR

    A specific method by which corporations can repurchase outstanding shares of their stock. The accelerated share repurchase (ASR) is usually accomplished by the corporation purchasing shares of its stock from an investment bank. The investment bank borrows the shares from clients or share lenders and sells them to the company.
  3. Microeconomic Pricing Model

    A model of the way prices are set within a market for a given good. According to this model, prices are set based on the balance of supply and demand in the market. In general, profit incentives are said to resemble an "invisible hand" that guides competing participants to an equilibrium price. The demand curve in this model is determined by consumers attempting to maximize their utility, given their budget.
  4. Centralized Market

    A financial market structure that consists of having all orders routed to one central exchange with no other competing market. The quoted prices of the various securities listed on the exchange represent the only price that is available to investors seeking to buy or sell the specific asset.
  5. Balanced Investment Strategy

    A portfolio allocation and management method aimed at balancing risk and return. Such portfolios are generally divided equally between equities and fixed-income securities.
  6. Negative Carry

    A situation in which the cost of holding a security exceeds the yield earned. A negative carry situation is typically undesirable because it means the investor is losing money. An investor might, however, achieve a positive after-tax yield on a negative carry trade if the investment comes with tax advantages, as might be the case with a bond whose interest payments were nontaxable.
Trading Center