These are the virtues of what a good backtest is and what it can do for investors. These are the virtues The Gold Standard for Portfolio Backtesting.
- Includes the impact of portfolio rebalancing
- Ideally, the backtest should cover a period long enough to cover at least two full market cycles. This is normally about 10 years.
- The process should be shielded from hindsight bias in the security selection
- The Portfolio Backtest must have a separation from the information that would be used to create the portfolio at the time of investing and the test results of those decisions. Investment professionals call this Out of Sample because the rest are tested outside of the sample data used to create it.
- Ideally, the backtest includes the impact of other lifecycle portfolio management decisions. Portfolio are more than just a collection of assets. Additional decisions such as when to take a profit, when to take a loss, when to hedge, when to increase or decrease overall exposure – all these things matter, and full lifecycle portfolio backtesting accounts for it.
- The results of the portfolio backtest must be presented in a manner that allows the investor to truly understand the investment strategy. Investors need more that just what the strategy returned. What are the risks? How does the performance compare? What did the portfolio hold at what times? Is it diversified?
- The portfolio backtests should work with your actual investments. Limitations on the backtest to a particular asset class or instrument may fail to capture your true strategy and dilute the relevance of the Backtest.
- The Backtest should be optimized! It sounds obvious but the backtest of a basket of stocks or bonds that are equally weighted or randomly allocated leaves money on the table and dilutes the potential of the strategy.
- A portfolio backtest can set reasonable expectations for future performance.
- A portfolio backtest enables the investor to test multiple strategies and variations without risking money or spending years accumulating actual investment results.
- A Backtest provides the Chassis that an investor can fit with to protect the investor from dangerous self-inflected decisions.
- Having your own backtest allows the results to be fully personalized, so it is relevant
- Backtesting your Portfolio is objective. A backtest is a truth telling engine. Maybe it is good, maybe it shows the strategy is too risky. Either way, you get the knowledge and you can choose.
- Backtesting is deliberate. The worlds best investors are always deliberate with their investment decisions.
- Includes periodic Re-Optimizations of the investments so each Re-Optimization provides an optimal weight for each investment based on the information that would have been available at that time. The more Re-Optimizations the better as each optimization diversifies the risk that the portfolio performance was a function of getting in on a great company early and riding it. The Backtest should backtest the strategy, not merely a collection of assets.