Blog - 10/16 - Eran Raviv

On the 60/40 portfolio mix

Blog, Finance and TradingPosted on 03/24/2016

Not sure why is that, but traditionally we consider 60% stocks and 40% bonds to be a good portfolio mix. One which strikes decent balance between risk and return. I don’t want to blubber here about the notion of risk. However, I do note that I feel uncomfortable interchanging risk with volatility as we most often do. I am not unhappy with volatility, I am unhappy with realized loss, that is decidedly not the same thing. Not to mention volatility does not have to be to the downside (though I just did).

Let’s take a look at this 60/40 mix more closely.

ASA statement on p-values

Blog, Miscellaneous, Statistics and EconometricsPosted on 03/14/2016

There are many problems with p-values, and I too have chipped in at times. I recently sat in a presentation of an excellent paper, to be submitted to the highest ranked journal in the field. The authors did not conceal their ruthless search for those mesmerizing asterisks indicating significance. I was curious to see many in the crowd are not aware of current history in the making regarding those asterisks.

The web is now swarming with thought-provoking discussions about the recent American Statistical Association (ASA) statement on p-values. Despite their sincere efforts, there are still a lot of back-and-forth over what they actually mean. Here is how I read it.

Useful reader comments

BlogPosted on 03/13/2016

This page shares some good comments readers make

Multivariate volatility forecasting, part 6 – sparse estimation

Blog, Finance and Trading, Risk, Statistics and EconometricsPosted on 02/15/2016

First things first.

What do we mean by sparse estimation?

Sparse – thinly scattered or distributed; not thick or dense.

Curse of dimensionality part 2: forecast combinations

Blog, Statistics and EconometricsPosted on 02/01/2016

In a previous post we discussed the term ‘curse of dimensionality’ and showed how it manifests itself, in practice. Here we give another such example.

Linear regression assumes nothing about your data

Blog, Statistics and EconometricsPosted on 01/25/2016

We often see statements like “linear regression makes the assumption that the data is normally distributed”, “Data has no or little multicollinearity”, or other such blunders (you know who you are..).

Let’s set the whole thing straight.

Linear regression assumes nothing about your data

It has to be said. Linear regression does not even assume linearity for that matter, I argue. It is simply an estimator, a function. We don’t need to ask anything from a function.

Consider that linear regression has an additional somewhat esoteric, geometric interpretation. When we perform a linear regression you simply find the best possible, closest possible, linear projection we can. A linear combination in your X space that is as close as possible in a Euclidean sense (squared distance) to some other vector y.

That is IT! a simple geometric relation. No assumptions needed whatsoever.

You don’t ask anything from the average when you use it as an estimate for the mean do you? So why do that when you use regression? We only need to ask more if we do something more.

Curse of dimensionality part 1: Value at Risk

Blog, Finance and Trading, Risk, Statistics and EconometricsPosted on 01/17/2016

The term ‘curse of dimensionality’ is now standard in advanced statistical courses, and refers to the disproportional increase in data which is needed to allow only slightly more complex models. This is true in high-dimensional settings. Here is an illustration of the ‘Curse of dimensionality’ in action.

Most popular posts – 2015

Blog, MiscellaneousPosted on 01/03/2016

The top three for the year are:
Out-of-sample data snooping
Code for my yield curve forecasting paper
Review of a couple of books
I personally enjoyed the most writing a few words on ML estimation, and about those great statistical discoveries. Since the last post did not involve any code or images I initially thought it would be a breeze. I in fact spent twice the time I usually do, and it was all good fun.

In 2015 I wrote quite a bit about volatility and correlation. In 2016 I plan to learn more (so to write more) about portfolio construction.

Present-day great statistical discoveries

Blog, Miscellaneous, Statistics and EconometricsPosted on 12/21/2015

Some time during the 18th century the biologist and geologist Louis Agassiz said: “Every great scientific truth goes through three stages. First, people say it conflicts with the Bible. Next they say it has been discovered before. Lastly they say they always believed it”. Nowadays I am not sure about the Bible but yeah, it happens.

I express here my long-standing and long-lasting admiration for the following triplet of present-day great discoveries. The authors of all three papers had initially struggled to advance their ideas, which echos the quote above. Here they are, in no particular order.

Multivariate volatility forecasting (5), Orthogonal GARCH

Blog, Finance and Trading, Risk, Statistics and EconometricsPosted on 12/06/2015

In multivariate volatility forecasting (4), we saw how to create a covariance matrix which is driven by few principal components, rather than a complete set of tickers. The advantages of using such factor volatility models are plentiful.

‘Predictions’, ‘forecasts’ or ‘projections’?

Blog, MiscellaneousPosted on 12/02/2015

Perhaps it is the different jargon used in different disciplines, not sure. But for some reason, the terms ‘predictions’, ‘forecasts’ and ‘projections’ are frequently used interchangeably.

Correlation and correlation structure (3), estimate tail dependence using regression

Blog, Finance and Trading, Risk, Statistics and EconometricsPosted on 11/10/2015

What is tail dependence really? Say the market had a red day and saw a drawdown which belongs with the 5% worst days (from now on simply call it a drawdown):

One can ask what is now, given that the market is in the blue region, the probability of a a drawdown in a specific stock?

Multivariate volatility forecasting (4), factor models

Blog, Finance and Trading, Risk, Statistics and EconometricsPosted on 10/20/2015

To be instructive, I always use very few tickers to describe how a method works (and this tutorial is no different). Most of the time is spent on methods that we can easily scale up. Even if exemplified using only say 3 tickers, a more realistic 100 or 500 is not an obstacle. But, is it really necessary to model the volatility of each ticker individually? No.

If we want to forecast the covariance matrix of all components in the Russell 2000 index we don’t leave much on the table if we model only a few underlying factors, much less than 2000.

Volatility factor models are one of those rare cases where the appeal is both theoretical and empirical. The idea is to create a few principal components and, under the reasonable assumption that they drive the bulk of comovement in the data, model those few components only.

Multivariate volatility forecasting (3), Exponentially weighted model

Blog, Finance and Trading, Risk, Statistics and EconometricsPosted on 10/12/2015

Broadly speaking, complex models can achieve great predictive accuracy. Nonetheless, a winner in a kaggle competition is required only to attach a code for the replication of the winning result. She is not required to teach anyone the built-in elements of his model which gives the specific edge over other competitors. In a corporation settings your manager and his manager and so forth MUST feel comfortable with the underlying model. Mumbling something like “This artificial-neural-network is obtained by using a grid search over a range of parameters and connection weights where the architecture itself is fixed beforehand…”, forget it!

Correlation and correlation structure (2), copulas

Blog, Risk, Statistics and EconometricsPosted on 09/21/2015

This post is about copulas and heavy tails. In a previous post we discussed the concept of correlation structure. The aim is to characterize the correlation across the distribution. Prior to the global financial crisis many investors were under the impression that they were diversified, and they were, for how things looked there and then. Alas, when things went south, correlation in the new southern regions turned out to be different\stronger than that in normal times. The hard-won diversification benefits evaporated exactly when you needed them the most. This adversity has to do with fat-tail in the joint distribution, leading to great conceptual and practical difficulties. Investors and bankers chose to swallow the blue pill, and believe they are in the nice Gaussian world, where the math is magical and elegant. Investors now take the red pill, where the math is ugly and problems abound.