Wednesday, August 24, 2022

The Complexity Principle (!)

Continuing the previous post, I'm sorry if I seem to be gushing over the recent Kelly et al. program (indeed I am), but it just blows me away.  The famous "parsimony" and "KISS (keep it sophisticatedly simple)" principles turned on their heads!  George Box and Arnold Zellner must be rolling in their graves...

 The Virtue of Complexity Everywhere

Bryan T. Kelly (Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)); Semyon Malamud (Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute); Kangying Zhou (Yale School of Management)

We investigate the performance of non-linear return prediction models in the high complexity regime, i.e., when the number of model parameters exceeds the number of observations. We document a "virtue of complexity" in all asset classes that we study (US equities, international equities, bonds, commodities, currencies, and interest rates). Specifically, return prediction R2 and optimal portfolio Sharpe ratio generally increase with model parameterization for every asset class. The virtue of complexity is present even in extremely data-scarce environments, e.g., for predictive models with less than twenty observations and tens of thousands of predictors. The empirical association between model complexity and out-of-sample model performance exhibits a striking consistency with theoretical predictions.

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