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    Demantra Bayesian White Paper PDF

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    Demantra Bayesian White Paper PDF

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    of 7

    The Bayesian Approach to

    Forecasting
    An Oracle White Paper
    Updated September 2006
    The Bayesian Approach to Forecasting

    INTRODUCTION
    The Bayesian approach uses a combination of a priori and post priori knowledge to
    The main principle of forecasting is to find
    model time series data. That is, we know if we toss a coin we expect a probability
    the model that will produce the best
    forecasts, not the best fit to the historical of 0.5 for heads or for tails—this is a priori knowledge. Therefore, if we take a coin
    data. The model that explains the historical and toss it 10 times, we will expect five heads and five tails. But if the actual result
    data best may not be best predictive is ten heads, we may lose confidence in our a priori knowledge. This may be
    model. explained by a change to the coin that was introduced to alter the probability—this
    is post priori knowledge. Another example of post priori knowledge is future price
    change or marketing promotion that is likely to alter the forecast.
    The main principle of forecasting is to find the model that will produce the best
    forecasts, not the best fit to the historical data. The model that explains the
    historical data best may not be best predictive model for several reasons.
    • The future may not be described by the same probability as the past. Perhaps
    neither the past nor the future is a sample from any probability distribution.
    The time series could be nothing more than a non-recurrent historical record.
    • The model may involve too many parameters. Overfitted models could
    account for noise or other features in the data that are unlikely to extend into
    the future.
    • The error involved in fitting a large number of parameters may be damaging
    to forecast accuracy, even when the model is correctly specified.
    In any of these cases, the model may fit the historical data very well, yet still
    forecast poorly, illustrating that there is a vast difference between its internal and
    external validities.

    The Bayesian Approach to Forecasting Page 2


    A forecasting model that includes all parameters poorly predicts historical data.

    From the graph above, we can see how a regular model with all the parameters
    cannot correctly predict the historical data. We would like to select a model that
    minimizes the forecasting error and not the historical data error.

    Forecasting Models Using Classical Statistical Methods


    Classical, or orthodox, statistics selects just the “best” model and rejects all the
    others, even if they are only marginally worse than the best model. Unfortunately,
    this limitation is often compounded by the well-known problem of over-fitting,
    where a model is excessively fine-tuned in order to explain the past, usually to the
    detriment of its predictive power.
    Bayesian analysis, in contrast, allows multiple data models of comparable high
    quality to be combined by assigning probabilities to each model. In addition to
    improving the accuracy and robustness of predictive abilities, this approach also
    adds considerable flexibility to the system.
    Causal factor selection is complicated by the fact that the number of candidate
    factors is often comparable to the total length of the data. Classical statistical
    methods either fail to work, or reject most of the causal factors. This can be
    especially frustrating if the user already knows, either through experience or
    common sense, that the candidate factors put forward are relevant. In that case,
    what is actually needed from the system is for it simply to measure the effect of the
    causal factors, rather than attempt to test for their relevance.
    Bayesian model averaging, a rapidly developing field of modern statistics, treats the
    problem in a very natural way. It tries out many small (overlapping) subsets of
    causal factors and determines that a causal factor should be considered relevant if,
    roughly speaking, it is found to participate in a sufficient number of the subsets—
    the bigger the number the higher the relevance. Consequently, the length of
    available history does not limit the number of causal factors that the user can put
    forward. Of course the user should avoid introducing causal factors that are, a

    The Bayesian Approach to Forecasting Page 3


    priori, totally irrelevant to the series in question as this simply slows down
    computation time and can sometimes affect forecast accuracy. But if the factor
    seems to be of some relevance, then it should be included and the data allowed to
    “speak for itself.” It is also worth mentioning that the same causal factor might be
    used for modeling at different levels, such as city and region; these would be
    estimated separately and recombined to improve forecast accuracy at all levels.

    Forecasting Models Using the Bayesian Approach


    The Bayesian approach combines the results of individual models. Each model is
    evaluated, and each model in turn tests a number of subsets of system and user-
    supplied causal factors (price is almost invariably a causal factor). All combinations
    of models and subsets of causal factors are assigned weights indicating their
    relevance. Every combination contributes to the final forecast according to its
    weighting. The reconciliation procedure ensures that the results meet the necessary
    constraint of parent-children relationship.
    The following figure depicts various approaches to forecasting. While most
    forecasting approaches rely on one of several methods, the Bayesian approach uses
    a statistically sound way of combining the advantages of each approach to generate
    the best forecast accuracy.

    Several forecasting approaches and the methods they use to generate forecasts.

    The Bayesian technique uses a methodology that can be described by the following
    equation: F = w1f1 + w2f2 + wnfn. Where F is the final forecast; f1 refers to the
    forecast using model 1; f2 refers to the forecast using model 2; fn refers to the
    forecast using model n and wj is a weight given to model j.
    The value assigned for weight takes into account the residuals, or the difference
    between the true data and estimated data. When determining the weight value, a

    The Bayesian Approach to Forecasting Page 4


    penalty factor is taken into consideration—the more parameters (causal factors)
    that need to be estimated, the bigger the penalty. If the number of causal factors is
    larger than, or about half of, the number of observations, then the estimation in
    general will be poor. Therefore the weight given to such a model will be small.

    The Demantra Demand Planner forecast engine automatically combines different forecast
    models in the same time series.

    Case Study: Bayesian Versus “Best-Fit” Approaches


    The following graph demonstrates that the Bayesian approach provides a forecast
    with accuracy as good as, or better than, the “best-fit” approaches common in the
    market.
    The customer data is from a global company with over US$9 billion in annual
    revenues. The customer provided two years of historical data. The objective was to
    use only the first 18 months of data to “forecast” the last six months sales by unit,
    and to compare the forecasted values to the actual values. Alternative forecasting
    scenarios were developed using models picked as best by competing vendors’
    packages, as well as the Bayesian approach.

    The Bayesian Approach to Forecasting Page 5


    Comparison of forecasting error values obtained with the Bayesian approach versus
    several other forecasting methodologies.

    The X-axis represents item IDs and the Y-axis represents relative error (calculated
    as Mean Absolute Percent error). For items 6740, 6759, 6753, 6872, 6873, and
    6877, the differences between the Bayesian and the “pick-best” approaches used by
    other vendors are relatively small (maximum absolute difference in MAPE is 4
    percent maximum; relative difference in MAPE is approximately 30 percent). The
    difference between the approaches is noticeable for other item IDs; it was as large
    as 25 percent on an absolute and more than 100 percent on a relative basis.

    CONCLUSION
    Because the behavior of items can differ from item to item, and in some cases from
    Bayesian analysis, in contrast, allows
    location to location, using one pick-best model to generate forecasts is not
    multiple data models of comparable high
    quality to be combined by assigning recommended. The Bayesian forecasting approach relies on an optimal
    probabilities to each model. In addition to combination model for each item and location combination. The engine adapts the
    improving the accuracy and robustness of model weights as new data becomes available so that the users do not have to track
    predictive abilities, this approach also product behavior and respecify the model usage manually, as some other
    adds considerable flexibility to the system.
    commercial packages require the user to do.
    The patented Bayesian analytical forecast engine used in Oracle Demantra planning
    solutions offers the most accurate forecasts possible. Automated algorithms
    consider 15 industry-standard and proprietary forecasting models, each geared to
    different demand patterns. The forecast engine automatically combines different
    forecast models in the same time series. This produces a forecast that
    accommodates seasonality, promotions, trends, and many other causal factors.

    The Bayesian Approach to Forecasting Page 6


    The Bayesian Approach to Forecasting
    Updated September 2006

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