What is data smoothing?
Data smoothing is performed using an algorithm to remove noise from a data set. This allows important models to stand out. Data smoothing can be used to help predict trends, such as those seen in security prices.
Smoothed data is preferred because it generally identifies changes in the economy compared to unsmoothed data.
Explanation of data smoothing
When the data is compiled, it can be manipulated to eliminate or reduce any volatility or any other type of noise. This is called data smoothing.
The idea behind data smoothing is that it can identify simplified changes to help predict different trends and patterns. It helps statisticians or traders who need to consult a large amount of data – which can often be difficult to digest – to find models that they would not otherwise see.
To explain with a visual representation, imagine a one-year graph for the stocks of Company X. Each individual high point on the stock graph can be reduced while increasing all the lower points. This would make the curve smoother, helping an investor to make predictions about the future performance of the stock.
Data smoothing methods
There are different methods for smoothing the data. Some of them include the random method, random walk, moving average, simple exponential, linear exponential and seasonal exponential smoothing.
A smoothed moving average places equal weight on recent and historical prices.
The random walk model is commonly used to describe the behavior of financial instruments such as stocks. Some investors believe that there is no relation between the past evolution of the price of a security and its future evolution. Smoothing random walk assumes that future data points will be equal to the last available data point plus a random variable. Technical and fundamental analysts disagree with this idea; they believe that future movements can be extrapolated by examining past trends.
Often used in technical analysis, the moving average smooths price action while filtering out the volatility of random price movements. This process is based on past prices, making it an indicator of trend (or lag).
Advantages and disadvantages of data smoothing
Data smoothing can be used to help identify trends in the economy, stocks such as stocks, consumer sentiment or other business purposes.
Key points to remember
- Data smoothing uses an algorithm to suppress noise from a data set, which allows large models to stand out.
- It can be used to predict trends, such as those seen in security prices.
- Different models of data smoothing include the random method, random walk, and the moving average.
- While smoothing the data can help predict certain trends, it can lead to skipping certain data points.
For example, an economist can smooth the data to make seasonal adjustments for certain indicators such as retail sales by reducing the variations that can occur each month such as holidays or gas prices.
However, the use of this tool has drawbacks. Smoothing the data does not always provide an explanation of trends or patterns that it helps to identify. It can also lead to skipping certain data points by focusing on others.