I was inspired to write this post after I read Foquant’s (formerly CPP Trader) post on Inductive versus Deductive Algorithms. He hits the nail on the head when he ends his article with:

Personally, I have used deductive reasoning to develop frameworks for money management methods, and then tested data in a similar, inductive method, to create the details.

There’s a reason why I like Foquant’s blog, he an I think the same way when we approach model building but he just likes to use fancy terms! :)

Because I’ve been in the corporate world too long, I prefer to use the terms “top down” and “bottoms up,” when building a financial/neural net model. However you can easily replace those terms with “deductive reasoning” and “inductive reasoning” respectively.

The bottoms up approach is where you have oodles of data and you spend time cluster mining for relationships or for statistically significant patterns. Over time you start building a model that will lead to your output variable. This method is very rigorous and time consuming method but the final model should be very robust.

The other approach, top down, is where you a lot of time observing your output variable (i.e. stock, currency, index) behaving in the market environment and try to figure out what makes it work. Once you think you have an idea on what makes your output variable function, you gather the appropriate input variables and then statistically try to prove their relevance. Of course if you find that your inputs aren’t as robust as you like them to be, you’ll have to spend additional time looking for the right ones.

Both approaches have their strengths and weaknesses and figuring out what approach to use to build a model really depends on the individual. While one method tends to be more trial and error (top down), the other tends to be more hypothesis testing (bottom up).

Personally I start with the top down approach to build a model and then to check it using a bottoms up approach, just like Foquant. This is perhaps the most time consuming way of building a financial model but its led to great success for me and I continue to use it to this day!