In financial machine learning, particularly when predicting between three classes like “buy,” “sell,” and “hold,” the choice between optimizing for high precision or high recall depends on various factors, including the specific goals of your model, the costs associated with false positives and false negatives, and the nature of the problem you’re addressing.
Let’s break down precision and recall:
Precision: Precision measures the accuracy of positive predictions made by the model. It answers the question: “Of all the instances predicted as positive, how many were actually positive?” Mathematically, precision is calculated as the ratio of true positives to the sum of true positives and false positives. High precision indicates that when the model predicts a certain class (e.g., “buy”), it is usually correct.
Recall: Recall measures the ability of the model to find all the relevant instances in the dataset. It answers the question: “Of all the actual positives, how many did the model correctly identify?” Mathematically, recall is calculated as the ratio of true positives to the sum of true positives and false negatives. High recall indicates that the model effectively captures most instances of a particular class.
Now, let’s consider scenarios where each metric might be prioritized:
High Precision
Low Tolerance for False Positives: If making a wrong prediction (such as labeling a “hold” as “buy” or “sell”) incurs significant costs or risks, prioritizing high precision is crucial. For instance, if falsely labeling a “hold” as a “buy” leads to unnecessary investments with potential losses, you’d want to minimize such errors.
Imbalanced Classes: In situations where the classes are imbalanced, i.e., one class has significantly fewer instances compared to others, optimizing for high precision can help avoid over-predicting the dominant class.
High Recall
Low Tolerance for False Negatives: If missing out on opportunities (e.g., failing to identify a good buying opportunity) is more costly than making occasional wrong predictions, prioritizing high recall is beneficial. In financial markets, missing out on profitable trades can be more detrimental than making some incorrect predictions.
Critical for Risk Management: When risk management is paramount, maximizing recall ensures that potentially risky situations are flagged, even if it means some false alarms. This is especially important in volatile markets where missing a significant market move can lead to substantial losses.
However, it’s important to note that precision and recall are trade-offs; improving one often comes at the expense of the other. Therefore, you might need to strike a balance based on your specific requirements. Additionally, using metrics that combine precision and recall, such as the F1 score or area under the precision-recall curve (AUC-PR), can provide a more comprehensive evaluation of your model’s performance. Experimentation and iterative refinement based on real-world feedback are key to finding the optimal balance for your financial machine learning application.
