The vast majority of investors wanting portfolio backtesting have good intentions. But even the well-intentioned investor may make some mistakes that can lead to dangerous consequences. These seven deadly sins of portfolio backtesting may cause misleading results and failure to achieve the expected results:
- Hindsight Bias: Did you really know that AAPL and GOOGL were going to be trillion-dollar companies? Investors fool themselves into believing that such inclusions are OK because they are obvious. But they are not. Having blindfolded or systematic selection processes protect against this bias.
- Survivorship bias: if you backtest stocks that exist no, the mere fact that they have not gone belly up yet creates a bias. The impact of this bias can vary greatly but for diversified strategy can be 1% to 3% overstated.
- A lack of diversity in the investments
- No optimization: failing to apply an intelligent weighting to the portfolio will likely result in several percentage points of underperformance.
- Cherry-picking the best of many backtests – who is to say that the results of the best backtest are more likely that the results of the worst ones? The more flawed and bias the backtest is the more this sin is dangerous. However, if applied to a credible portfolio backtesting process this could be ok.
- Buy and Hold backtests can be instructive of historical performance but have decreased usefulness to predict the future. Instead of backtesting a reproducible strategy it is merely seeing how a collection of assets would have done.
- A lack of diversification in the investment process. The more narrow the focus of the strategy the more time and backtested event needs to be to make the results credible. Diversification of the investment process is almost as important as diversification of the portfolio!
James’ professional orientation points at the zenith (and sometimes nadir) where technology and investments intersect. He is a Fintech entrepreneur and has served twenty years of a lifetime sentence.
James is a patented inventor, quant pioneer and investment manager. He is the founder of Gravity Investments, a unique investment and technology services firm centered on James’ inventions for diversification measurement, optimization, visualization, and analysis. In the development of the platform, James has pioneered A.I applications, diversification attribution, down-side diversification, portfolio re-optimization, full-lifecycle strategy optimization, programmable investment policy statements and core-satellite optimization techniques.
In working with advisors, funds and money managers as both a strategic sub-advisor and software consultant, James has consulted and trained hundreds of professional investors on portfolio design and optimization. James has a unique ability to look at any investment process and find practical, intelligent and often quantifiable opportunities to improve the investment product.
Inspired by the work of Nobel Laureate Harry Markowitz and the efficient frontier, James has championed and pioneered the science of diversification. James’ technology has advised
or assisted in over 30 Billion dollars of investor capital. His vision of a more perfect investment management system is at the heart of Gsphere ( www.gsphere.net )
His passion for performance, curiosity for the unknown, and drive to excel empower his service to investors.
James is Founder and CEO of Portfolio ThinkTank (the B2C company) www.portfoliothinktank.com, Founder & Chief of Financial Engineering at Gravity Investments www.gravityinvestments.com (the B2B company) and Chief Investment Officer at Gravity Capital Partners, a wholly owned SEC Registered Investment Advisor.