One of the basic premises for model development is the concept of Occam’s Razor. Occam’s (or Ockham’s) razor is a principle attributed to the 14th-century logician and Franciscan friar William of Ockham. This is the basic premise of all scientific and theory building. The simpler of two methods is preferable. Simplest may not be best, but is a good start.
It is the only form that takes its own advice: Keep things simple. A model built on sound principles will probably survive the tumult of the markets much longer and better than an overly complex model. Complexity has a tendency to fail, and unfortunately, usually at the worst time. I always think about the complex algorithms used by Long Term Capital in 1998, when they began to fail miserably. Their complete failure and the foolish effort to tweak them almost took the New York Fed down with them. It seems that too often investors associate complexity with viability. That is just not correct.
There are three primary components to a sound model, and just like a three-legged stool, a model must be stable in all environments. They are:
- Weight of the evidence measurement of market movement.
- Rules and guidelines to show how to trade the weight of the evidence information.
- Strict discipline to follow the process ...