Interesting post. As you model financial markets, what approach or approaches do you take to avoid model over-specification?

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Jul 3, 2022·edited Jul 3, 2022Author

Step one is a sense of persistent doubt that is inherent to my being. On top of that, using informative priors can help as they intrinsically regularize your model.

More helpfully, in the same course/textbook mentioned above (Richard McElreath's Statistical Rethinking) a causality-directed approach is suggested which avoids the "causal salad" of over-specified models. First you draw yourself a structural causal model that includes every variable and how they should relate to each other. This model will have consequences and it can be disproven. You can't include spurious variables unless you have a good sense for how they could actually causally interact with your outcome. You can test the consequences of your model to validate it, and when your model is wrong it also tells you something useful about your scientific understanding inherent in your structural model.

When a good model is wrong, you learn something. When a bad model is wrong, you don't learn anything. Starting with a structural model of causality helps us make good models that teach us something even if they are wrong.

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