DEFINITION of 'Overfitting'

Overfitting is 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 often studied 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.

RELATED TERMS
  1. Model Risk

    Model risk occurs when a financial model used to measure a firm's ...
  2. Central Limit Theorem - CLT

    A statistical theory that states that given a sufficiently large ...
  3. Non-Sampling Error

    A non-sampling error is an error that results during data collection, ...
  4. Accounting Error

    An accounting error is an error in an accounting entry that was ...
  5. Error Term

    A variable in a statistical and/or mathematical model, which ...
  6. Predictive Modeling

    Predictive modeling is the process of using known results to ...
Related Articles
  1. Trading

    Build a Profitable Trading Model In 7 Easy Steps

    Trading models can provide a powerful tool for building profit. Traders can use and customize existing trading models or build an original model. This article provides seven steps to building ...
  2. Investing

    The Basics Of Business Forecasting

    Discover the methods behind financial forecasts and the risks inherent when we seek to predict the future.
  3. Investing

    Understanding the Modigliani-Miller Theorem

    The Modigliani-Miller (M&M) theorem is used in financial and economic studies to analyze the value of a firm, such as a business or a corporation.
  4. Investing

    More Model 3 Details Emerge on Tesla Earnings Call

    Tesla said the Model 3 will have fewer "bells and whistles" but a more automated production process to enable scale.
  5. Tech

    How to Code Your Own Algo Trading Robot

    Ever wanted to become an algorithmic trader with the ability to code your own trading robot?
  6. Insights

    The Fed Model And Stock Valuation: What It Does And Does Not Tell Us

    Learn about this popular stock market valuation model and how accurate it has been over the years.
  7. Investing

    Digging Into The Dividend Discount Model

    The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions.
  8. Investing

    Financial Forecasting: The Bayesian Method

    This method can help refine probability estimates using an intuitive process.
  9. Personal Finance

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
RELATED FAQS
  1. What is a relative standard error?

    Find out how to distinguish between mean, standard deviation, standard error and relative standard error in statistical survey ... Read Answer >>
  2. How do I calculate the standard error using Matlab?

    Learn how to calculate the standard error for a sample statistical measure, such as the sample mean, using standard Matlab ... Read Answer >>
  3. How is the standard error used in trading?

    Understand how the standard error is used in statistics and what it measures. Learn how the standard error is used in trading ... Read Answer >>
  4. What's the difference between a representative sample and a random sample?

    Explore the differences between representative samples and random samples, and discover how they are often used in tandem ... Read Answer >>
  5. How can I calculate the tracking error of an ETF or indexed mutual fund?

    Understand what tracking error for index ETFs or mutual funds is, and how to calculate it. Learn about the difference it ... Read Answer >>
  6. What is Fisher's separation theorem?

    Fisher's separation theorem stipulates that the goal of any firm is to increase its value to the fullest extent, regardless ... Read Answer >>
Hot Definitions
  1. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  2. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  3. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  4. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  5. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  6. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
Trading Center