Accuracy and Precision in Finance
9 Pages Posted: 3 Dec 2015
Date Written: September 30, 2015
Modern finance, both theoretical and practical, makes extensive use of mathematical reasoning and modelling. But this reliance on exact methods comes with unfortunate side effects: numerical precision is emphasised, but without an equal insistence on empirical accuracy; methods that do not offer numerical precision are shunned from the beginning. This is most severe in those fields of finance in which theories build on optimisation. We argue that precision in modelling is only useful up to a certain level; we can do with approximations and low precision as long as models are sufficiently accurate for the purpose at hand. We illustrate this view through a concrete example: selecting financial portfolios with so-called heuristic methods. Heuristics provide only approximations to an optimisation model's solution, but we show that their precision is sufficient for all practical purposes. In compensation for their lack of precision, heuristics allow researchers to solve more-accurate models.
Keywords: heuristics, portfolio optimisation, model validation, model risk
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