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.

BREAKING DOWN '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.

  1. Financial Modeling

    The process by which a firm constructs a financial representation ...
  2. Stochastic Modeling

    A method of financial modeling in which one or more variables ...
  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. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
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

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  7. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  8. Economics

    Understanding Tragedy of the Commons

    The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
  9. Professionals

    Top 3 Misconceptions About Financial Analysts

    Learn misconceptions about financial analysts, such as they exclusively study the stock market, they are the same as financial advisors and they are all rich.
  10. Fundamental Analysis

    Return on Investment (ROI) Vs. Internal Rate of Return (IRR)

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  1. Is Colombia an emerging market economy?

    Colombia meets the criteria of an emerging market economy. The South American country has a much lower gross domestic product, ... Read Full Answer >>
  2. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  3. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
  4. How does the stock market react to changes in the Federal Funds Rate?

    The stock market reacts to changes in the federal funds rate in various ways depending on where it is in the business cycle. ... Read Full Answer >>
  5. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  6. What are the requirements for being a Public Limited Company?

    The requirements for an entity to be considered a public limited company (PLC) include registration requirements, establishing ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center