How to make the best decision

Choose one from many or combine them all?

By Professor Alan Wan

Professor Alan Wan, Head of the Department of Management Sciences, argues that combining statistical models offers advantages in forecasting compared to selection of a single model, that the approach is an increasingly used analytical tool in applied statistical work, and will likely become a toolkit in the statistician's repertoire in the future. This article is related to a number of model averaging papers published by Professor Wan in the Journal of the American Statistical Association, Journal of Econometrics, and Journal of Business & Economic Statistics.


It's decision time: The CEO could ask: "Which board member do I trust most?" Or think, "Everybody has expertise. I'll listen to them all." Which approach is better?

One of Hong Kong's largest property developers is pitching towards the millennial market for its new waterfront project. The CEO has to decide whether it is worth building to outstanding environmental standard, with the aim of attracting a young "greenminded" clientele. The decision depends on a forecast for how big the millennial market will be in the coming year. There is an impressive array of ten professionals on the board including engineers, financial experts, marketing professionals, audit and risk management, etc. The CEO knows his advisors well and clearly has greater trust in some than in others. The ten advisors give their forecasts, and he is left with ten numbers. How should he make a final selection from these ten numbers? The CEO could ask himself: "Which board member do I place the greatest trust in?" And then take his or her advice. Another approach would be for the CEO to say: "All the advisors have some valuable expertise to offer, although not all of the same importance. Some professions are more significant in this forecast and should get a higher weighting." Which way of thinking is the better? Intuitively, most people would go for the second method, where a wide spectrum of professional advice is taken into consideration. You may be surprised, however, to hear that in standard statistics, up to now it is the first method that has won out. Let me explain how things are changing.

What is a model?

With several models to choose from, researchers like to know which one is more consistent with the data.

Researchers working in different fields in the hard sciences through to the social sciences come up with a variety of ideas in their attempts to explain various phenomena. These conjectures are typically referred to as "models" for the phenomena of interest. Often these models sketch out broad relationships and attributes that may be relevant, but do not contain numerical detail and hence are in this sense incomplete. To flesh out this detail, researchers use methods in statistics to estimate their models. Statistical analysis allows them to fill in the missing numerical detail. With several estimated models to choose from, researchers like to know which one is more consistent with the evidence provided by the data. Fortunately, statistics can also help them make this decision. Deciding which model is best is referred to as "model selection".

OBut sometimes the model selection approach provides no clear winner with several models being equally good or equally bad descriptions. This motivated statisticians to come up with another approach. Instead of simply trying to decide which model ‘fits' data best, they thought why not construct a new model that is a weighted average of the best models? This approach is referred to as model averaging.

With these two modelling strategies available, statisticians now have to decide which to use in different circumstances.

A further complication is that statisticians have come up with many different ideas about how to go about model selection and how to implement model averaging. And also, there are many ideas about how to determine which of these various approaches is the best to use. Statisticians have developed many different criteria to judge them by.

Model selection ‒ not so easy

You have many potential models to choose from, and different strategies to arrive upon a final model.

On the face of it, model selection might appear to be straightforward. You have a number of competing models and some criteria to judge which is best. But the process is not so easy. You have many potential models to choose from and many to discard, and different strategies to arrive upon a final model.

One strategy is the specification search approach. In this approach the researcher uses sequential hypothesis testing to "pretest" and eliminate or keep different variables or specifications and use the process to arrive at a final specification.

Typically, statisticians would start from a single model which they estimated from data and a simple hypothesis to test. Is the model correct or not? Is an estimated coefficient significant or not? In this context some very basic statistical approaches and ideas about hypothesis testing were developed to decide if a model "worked."

That sort of approach is not so problematic when you test a single hypothesis. But statisticians later demonstrated that this approach doesn't work so well when you have several models that you are testing, or have multiple hypotheses or specifications to be tested sequentially. Specification searches by pretesting or statistical selection criteria, including what is referred to as "step-wise" regression, are widely practiced. In these cases, the standard statistical tests that you might use for a single hypothesis were demonstrated to be no longer valid due to what is referred to as "pretesting bias", and adjustments to the hypothesis testing procedure need to be made. In applied studies, however, researchers usually ignore these issues and report their statistical results as if no specification search has been performed. Statisticians have long been made aware that ignoring pretesting can result in very serious consequences.

These problems encountered in model selection and in testing hypotheses sequentially resulted in the development of many different ideas and approaches.

Much of my earlier work involved developing and refining some of these approaches and exploring the problem of and correcting for the pretesting bias.

Model averaging offers advantages

The basic idea of model averaging is to minimise risk.

As mentioned, the hypothesis testing and other selection frameworks used in the model selection approach, where many competing models are discarded, create problems like pretesting bias.

One advantage of the model averaging approach is that there is no discarding of any of the competing models and no subsequent specification searches by hypothesis testing, hence the problems encountered with model selection no longer exist.

Model averaging is also a great approach because frequently no single model stands out clearly from the rest, so there are obvious merits in attempting to average them.

The basic idea of model averaging, that is to minimise risk, is used in many contexts. Individuals, businesses and governments use the idea and try to spread their risk by averaging in various ways.

Individuals do it when investing. A wise investor avoids putting all their money into a single business if possible. Instead they prefer a diversified portfolio averaging the returns over several businesses and asset classes. Also, many large businesses will attempt to mitigate risk by diversifying so that if one part of their business is doing poorly they can still provide shareholders with a reasonable average return. Similarly, governments will rarely rely on a single expert when formulating policy. They frequently canvas a wide range of opinion and try to arrive at some sort of consensus or average position.

Model averaging was a natural idea for statisticians to adopt and an increasing number of researchers are now using the model averaging approach following the seminal paper "Frequentist model average estimators" by the Norwegian statistician Nils Lid Hjort and Belgian statistician Gerda Claeskens published in a 2003 issue of the Journal of the American Statistical Association. Since that paper, there has been a spurt of research activity on model averaging in the space of just a few years. A lot of my recent work has focused in this area.

Research has shown that by combining competing models you can generally produce more accurate predictions than those obtained from a single model. This is especially true when the underlying model or data has a high "noise" (i.e., unexplained irregularities) content, making it difficult for pretesting and model selection methods to single out one manifestly preferred model. Model averaging has been successfully applied in many disciplines including biomedical sciences, climatology, ecology, economics, finance and tourism.

Contrasting the different approaches

Here, I revisit two examples from one of my earlier papers published in the Annals of Tourism Research to illustrate the dangers of pretesting and model selection in terms of introducing bias by underreporting the variability of estimates and how model averaging can be used to overcome these issues and provide more accurate results.

Correct bounds wider; WALS more accurate

The first example is based on an analysis undertaken by the U.S. Department of Agriculture (USDA) in 2005 that investigated the degree to which recreation and tourism development influence various socioeconomic indicators including earnings per job, income per capita levels, death rates and others, in some 311 rural US counties in the year 2000.

Researchers from the USDA estimated a sequence of multiple regression models using a distinct socioeconomic indicator as their dependent variable. Their key explanatory variable was a Z-score which measures the county's dependency on recreation and tourism, and covers tourism-related employment and income shares of the local economy, as well as the share of total county homes dependent on recreational use. The higher the Z-score the more dependent a county is on recreation and tourism. The USDA was primarily interested in the coefficient estimate of the Z-score. The other explanatory variables are listed in Table 1.

Table 1: List of variables

Methods and Results

I used their study to analyse the effect of pretesting and highlight the merits of model averaging as an alternative to model selection.

To illustrate the effects of pretesting I used a popular stepwise regression procedure. This kind of model selection approach is so common that automated routines for stepwise selection are available in most statistical software packages. To produce the model averaging results, I used a technique known as weighted average least squares (WALS), introduced by the renowned Dutch econometrician Jan Magnus.

Estimates using both approaches, for the coefficient of interest, the Z-score, are in Table 2.

Table 2: Estimates of coefficient of Z-score in each regression and confidence bounds
1. Models 1-16 are based on, respectively, dependent variables 1-16 listed in Table 1.

Column 2 of Table 2 provides the estimates based on the model selected by stepwise selection for each regression. The third column provides the 95% confidence bounds for those coefficients when pretesting has not been taken into account. These are the confidence bounds usually reported in applied work when the researcher assumes (erroneously) that the model has been chosen a priori and not as a consequence of model selection. The confidence bounds reported in Column 4, on the other hand, are the correct 95% confidence bounds paying due attention to consequent effect of stepwise selection on the variability of the estimates.

In all cases the commonly reported confidence bounds that ignored pretesting underreported the true confidence bounds. As this example illustrates, the difference between the reported and the correct confidence bounds can be very large. In the worst case, the true confidence bounds were almost 11 times as wide as the bounds that ignore pretesting; on average they are about three times as wide.

The WALS coefficient estimates and the 95% confidence bounds appear in Columns 5 and 6 respectively. In all cases the WALS and pretest coefficient estimates have the same sign and similar magnitudes. However, without exception the WALS estimates produced tighter confidence bounds than the (true) pretest confidence bounds. On average, the WALS confidence bounds are 43% the width of the correct pretest confidence bounds; thus notable reductions in estimator variability are achievable with the WALS approach. This is to be expected because model averaging usually leads to estimates that are of superior precision than those achieved by selecting a single model, as has been demonstrated in the theoretical literature. While these results are, of course, specific to the data example considered here, the evidence does provide an indication of the performance gains that are possible.

Model averaging – better prediction

The second example illustrates the benefits of using model averaging to improve forecasting accuracy when using common time series models.

To illustrate these advantages I used data on the number of longstay visitor arrivals in Barbados between 1956 and 1992 from a paper published in the Annals of Tourism Research. In that paper the author, Gerald Dharmaratne, estimated two ARIMA models using the data up to 1987 and then used the models to forecast the remaining years, and evaluated the accuracy of the resulting forecasts.

Dharmaratne used a model selection approach to choose his preferred forecasting model. The criterion he used was the AIC score, where a lower score suggests a model should provide better forecasts. For the less complex ARIMA(2,1,1) model, the AIC score is only slightly better. Nevertheless, under the model selection approach this is the preferred model for forecasting. And as it turned out, this model's forecasting performance is significantly better.

My study demonstrated that when there is no predominant model to call on, forecast accuracy could be further improved by combining results from the two models. I applied model averaging using a smoothed AIC weighting scheme to generate forecasts for those same remaining years.

Table 3: Forecast Comparisons

Table 3 presents the forecasts and a measure of their accuracy — their absolute percentage errors. The forecast performance of the second model, the ARIMA(2,1,1) (1,1,1)5, is rather poor. Except for 1992 its predictions are always worse, usually by a large margin. In comparison, the forecast performance of the averaged model is quite remarkable. In all cases the forecasts are closer to the true values than those obtained from the better of the two Dharmaratne models.

My averaged model has a mean absolute percentage forecast error of less than 9%, while the corresponding figures for the Dharmaratne models are almost 10% for the more accurate model and almost 20% for the other model.


The specific techniques I used in the preceding examples are just two of many model averaging techniques from the literature now available for researchers. Model averaging has been an increasingly used analytical tool in a lot of applied work. Undoubtedly, this approach will be used more extensively in the future.

Professor Alan Wan
Department of Management Sciences