Quant investing: What is overfitting?

Hue Frame

Frame Funds Management

An overfitted trading strategy is a model that has been trained on a specific dataset and has learned the noise in that dataset, rather than the underlying trend. This results in the model performing well on the training dataset, but poorly on new, unseen data. This is because the model has learned the noise in the training dataset, and is not able to generalize well to new data.

Overfitting can occur when a model is too complex for the amount of data that is available for training. For example, using too many indicators or inputs in a strategy can lead to overfitting. Additionally, overfitting can also occur when a model is trained on a small dataset, or when a model is trained on a dataset with a lot of noise.

How do you avoid overfitting?

1. Sample size

The law of large numbers states that as the number of trials in an experiment increases, the average of the results obtained from the trials will converge toward the expected value of the underlying probability distribution.

2. Strategy simplicity

The more complicated the strategy is, the higher the possibility is that it has been overfitted during the optimisation process.

3. In & out of sample testing

Another way to avoid overfitting is to use out-of-sample testing, which involves testing the model on a dataset that was not used for training. This can help to ensure that the model is not overfitting the training data and is able to generalize well to new data.

In summary, overfitting is a common problem in trading strategy, it occurs when a model has learned the noise in a specific dataset rather than the underlying trend. This results in the model performing well on the training dataset but poorly on new, unseen data. To avoid overfitting, it is important to use a sufficient amount of data for training, to keep the model as simple as possible, and to use cross-validation, regularization techniques, and out-of-sample testing. 

To find out more about the specific quantitative strategies we implement, please call our office on 02 8668 4877.

This information is prepared by Frame Funds Management Pty Ltd (ACN 608 862 442) (Frame Funds, we or us) is a Corporate Authorised Representative (CAR No. 123 9068) of Primary Securities Limited (ACN 089 812 812 635) and is intended only for "wholesale clients" within the meaning of sections 761G and 761GA of the Corporations Act 2001 (Cth). This material is not intended to constitute advertising or advice (including legal, tax or investment advice) of any kind. These materials are not to be distributed to any person who does not qualify as a wholesale client and must not be copied, reproduced, published, disclosed or passed to any other person at any time without the prior written consent of Frame Funds. Primary Securities Ltd (ACN 089 812 635 635, AFSL 224 107) is the Trustee of, and issuer of units in, the Frame Futures Fund and the Frame Long Short Australian Equity Fund (Funds). In deciding whether to acquire, or to continue to hold, units in the Fund please read the current Information Memorandum available from Frame Funds. Past performance of the Funds is not a reliable indicator of future performance. The value of an investment in the Funds may rise or fall. Returns are not guaranteed by any person. Total returns are calculated before tax and after ongoing management costs. In preparing this information, we have not considered your investment objectives, financial situation or personal circumstances and therefore the Funds may not be suitable for you. Neither Frame Funds, Primary Securities Ltd, nor any of their respective related parties, directors or employees, make any representation or warranty as to the accuracy, completeness, reasonableness or reliability of the information contained in this publication or accept liability or responsibility for any losses, whether direct, indirect or consequential, relating to, or arising from, the use or reliance on any part of this material. Any rates of return, forecasts or estimates contained in this publication are not guaranteed. The content of this publication is current as at the date of its publication and is subject to change at any time. It does not reflect any events or changes in circumstances occurring after the date of publication.

Hue Frame
Frame Funds Management

Hue Frame is the founder of Frame Funds Management. Frame Funds is a quantitative funds management company, that manages assets for institutional and wholesale clients, and proprietary funds.

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