Encyclopedia of Financial Models II

Model Selection and Its Pitfalls

SERGIO M. FOCARDI, PhD

Partner, The Intertek Group

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

PETTER N. KOLM, PhD

Director of the Mathematics in Finance Masters Program and Clinical Associate Professor, Courant Institute of Mathematical Sciences, New York University

Abstract: Financial modelers have to solve the critical problem of selecting or perhaps building the optimal model to represent the phenomena they seek to study. The task calls for a combination of personal creativity, theory, and machine learning.

In this entry we discuss methods for model selection and analyze the many pitfalls of the model selection process.

MODEL SELECTION AND ESTIMATION

In his book Complexity, Mitchell Waldrop (1992) describes the 1987 Global Economy Workshop held at The Santa Fe Institute, a research center dedicated to the study of complex phenomena and related issues. Organized by the economist Bryan Arthur and attended by distinguished economists and physicists, the seminar introduced the idea that economic laws might be better understood applying the principles of physics and, in particular, the newly developed theory of complex systems. The seminar proceedings were to become the influential book The Economy as an Evolving Complex System (Anderson, Arrow, and Pines, 1998).

An anecdote from the book is revealing of the issues specific to economics as a scientific endeavor. According to Waldrop, physicists attending the seminar ...