Statistical Shrinkage (4) – Covariance estimation

A common issue encountered in modern statistics involves the inversion of a matrix. For example, when your data is sick with multicollinearity your estimates for the regression coefficient can bounce all over the place.

In finance we use the covariance matrix as an input for portfolio construction. Analogous to the fact that variance must be positive, covariance matrix must be positive definite to be meaningful. The focus of this post is on understanding the underlying issues with an unstable covariance matrix, identifying a practical solution for such an instability, and connecting that solution to the all-important concept of statistical shrinkage. I present a strong link between the following three concepts: regularization of the covariance matrix, ridge regression, and measurement error bias, with some easy-to-follow math.

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Statistical Shrinkage (3)

Imagine you’re picking from 1,000 money managers. If you test just one, there’s a 5% chance you might wrongly think they’re great. But test 10, and your error chance jumps to 40%. To keep your error rate at 5%, you need to control the “family-wise error rate.” One method is to set higher standards for judging a manager’s talent, using a tougher t-statistic cut-off. Instead of the usual 5% cut (t-stat=1.65), you’d use a 0.5% cut (t-stat=2.58).

When testing 1,000 managers or strategies, the challenge increases. You’d need a manager with an extremely high t-stat of about 4 to stay within the 5% error rate. This big jump in the t-stat threshold helps keep the error rate in check. However that is discouragingly strict: a strategy which t-stat of 4 is rarity.

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Statistical Shrinkage (2)

During 2017 I blogged about Statistical Shrinkage. At the end of that post I mentioned the important role signal-to-noise ratio (SNR) plays when it comes to the need for shrinkage. This post shares some recent related empirical results published in the Journal of Machine Learning Research from the paper Randomization as Regularization. While mainly for tree-based algorithms, the intuition undoubtedly extends to other numerical recipes also.

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Trees 1 – 0 Neural Networks

Tree-based methods like decision trees and their powerful random forest extensions are one of the most widely used machine learning algorithms. They are easy to use and provide good forecasting performance off the cuff more or less. Another machine learning community darling is the deep learning method, particularly neural networks. These are ultra flexible algorithms with impressive forecasting performance even (and especially) in highly complex real-life environments.

This post is shares:

  • Two academic references lauding the powerful performance of tree-based methods.
  • Because both neural networks and tree-based methods are able to capture non-linearity in the data, it’s not easy to choose between them. Those references help form an opinion with regards to when one should use neural networks and when tree-based methods are preferable, if you don’t have time to implement both (which is usually the case).
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    Understanding Convolutional Neural Networks

    Convolutional Neural Networks (CNNs from here on) triumph in the field of image processing because they are designed to effectively handle strong spatial dependencies. Simply put, adjacent pixel-values are close to each other, often changing only gradually from one pixel to the next. In a picture where you wear a blue shirt, all the pixels in that area of the picture are blue. You can think of a strong autocorrelated time series, just for spatial data rather than sequential data. This post explains few important concepts related to CNNs: sparsity of connections, parameter sharing, and hierarchical feature engineering.

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    Correlation and Correlation Structure (6) – Distance Correlation

    While linear correlation (aka Pearson correlation) is by far the most common type of dependence measure there are few arguably better ways to characterize\estimate the degree of dependence between variables. This is a fascinating topic I keep coming back to. There is so much for a typical geek to appreciate: non-linear dependencies, should we consider the noise in the data or rather just focus on the underlying process, should we consider the whole distribution or just few moments.

    In this post number 6 on correlation and correlation structure I share another dependency measure called “distance correlation”. It has been around for a while now (2009, see references). I provide just the intuition, since the math has little to do with the way distance correlation is computed, but rather with the theoretical justification for its practical legitimacy.

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    Similarity and Dissimilarity Metrics – Kernel Distance

    In the field of unsupervised machine learning, similarity and dissimilarity metrics (and matrices) are part and parcel. These are core components of clustering algorithms or natural language processing summarization techniques, just to name a couple.

    While at first glance distance metrics look like child’s play, the fact of the matter is that when you get down to business there are a lot of decisions to make, and who likes that? to make matters worse:

    • Theoretical guidance is nowhere to be found
    • Your choices and decisions matter, in the sense that results materially change

    After reading this post you will understand concepts like distance metrics, (dis)similarity metrics, and see why it’s fashionable to use kernels as similarity metrics.

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    Hyper-Parameter Optimization using Random Search

    Hyper-parameters are parameters which are not estimated as an integral part of the model. We decide on those parameters but we don’t estimate them within, but rather beforehand. Therefore they are called hyper-parameters, as in “above” sense.

    Almost all machine learning algorithms have some hyper-parameters. Data-driven choice of hyper-parameters means typically, that you re-estimate the model and check performance for different hyper-parameters’ configurations. This adds considerable computational burden. One popular approach to set hyper-parameters is based on a grid-search over possible values using the validation set. Faster and simpler ways to intelligently choose hyper-parameters’ values would go a long way in keeping the stretched computational cost at a level you can tolerate.

    Enter the paper “Random Search for Hyper-Parameter Optimization” by James Bergstra and Yoshua Bengio, suggesting with a straight face not to use grid-search but instead, look for good values completely at random. This is very counterintuitive, for how can a random guesses within some region compete with systematically covering the same region? What’s the story there?

    Below I share the message of that paper, along with what I personally believe is actually going on (and the two are very different).

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    What is the Kernel Trick?

    Every so often I read about the kernel trick. Each time I read about it I need to relearn what it is. Now I am thinking “Eran, don’t you have this fancy blog of yours where you write about statistics you don’t want to forget?” and then: “why indeed I do have a fancy blog where I write about statistics I don’t want to forget”. So in this post I explain the “trick” in kernel trick and why it is useful.

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    Local Linear Forests

    Random forests is one of the most powerful pure-prediction algorithms; immensely popular with modern statisticians. Despite the potent performance, improvements to the basic random forests algorithm are still possible. One such improvement is put forward in a recent paper called Local Linear Forests which I review in this post. To enjoy the read you need to be already familiar with the basic version of random forests.

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    A New Parameterization of Correlation Matrices

    In volatility modelling, a typical challenge is to keep the covariance matrix estimate valid, meaning (1) symmetric and (2) positive semi definite*. A new paper published in Econometrica (citing from the paper) “introduces a novel parametrization of the correlation matrix. The reparametrization facilitates modeling of correlation and covariance matrices by an unrestricted vector, where positive definiteness is an innate property” (emphasis mine). Econometrica is known to publish ground-breaking research, and you may wonder: what is the big deal in being able to reparametrise the correlation matrix?

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    What’s the big idea? Deep learning algorithms

    Deep learning algorithms are increasingly featuring in popular news outlets, large-scale media events and academic conferences. But what makes them so popular? Why now?

    I recently published what I hope is an easy read for all of you modern-statistics geeks lovers; explaining the thrust behind this machine-learning class of models.

    You can download the two-pager from Significance, specifically here (subscription required).

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    Bayesian vs. Frequentist in Practice, part 3

    This post is inspired by Leo Breiman’s opinion piece “No Bayesians in foxholes”. The saying “there are no atheists in foxholes” refers to the fact that if you are in the foxhole (being bombarded..), you pray! Leo’s paraphrase indicates that when complex, real problems are present, there are no Bayesian to be found.

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    Random forest importance measures are NOT important

    Random Forests (RF from here onwards) is a widely used pure-prediction algorithm. This post assumes good familiarity with RF. If you are not familiar with this algorithm, stop here and see the first reference below for an easy tutorial. If you used RF before and you are familiar with it, then you probably encountered those “importance of the variables” plots. We start with a brief explanation of those plots, and the concept of importance scores calculation. Main takeaway from the post: don’t use those importance scores plots, because they are simply misleading. Those importance plots are simply a wrong turn taken by our human tendency to look for reason, whether it’s there or it’s not there.

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