Frequently Asked Questions

What is a Backtest?

A backtest is a historical simulation which serves to test the historical and sometimes future performance of a portfolio or trading strategy.

How do I backtest a portfolio?

The easiest way to backtest your portfolio is to enter it into Portfolio ThinkTank,

Lot of back testing now happens in python or Matlab.  Most systems on the web offer just a basic look back on a series of assets without any additional portfolio logic included to the test.

What do I need to watch out for in my back test?

Please see the seven deadly sins of portfolio back-testing

How do you measure portfolio diversification?

To measure the diversification in a portfolio you can follow the system as described in this infographic:

Are back tests reliable?

Not usually, but they can be.  You should be able to trust backtest results from a reputable financial institution.  

Backtest results from novice investors should likely not be trusted unless they verified they’ve gone through the necessary steps and process which makes the results more useful.

Here is a chart of factors that help make backtests more reliable:

Longer period – longer test periods generally make a backtest more reliable, especially when testing throughout the ups and downs of a market cycle and ideally over multiple market cycles,  testing over multiple market cycles is especially good since each market cycles has elements that are unique and elements that are common so backtesting a portfolio strategy this way will reveal more about the strategy than just the holdings at any one time.

More diversification.  This one is critical.  Think of it like this here in 2020, you can backtest a momentum-based technical indicator on AMZN.   Chances are it will look good.   AMZN has had great momentum for 20 years.   This test is worthless to reveal anything about the quality of the strategy.   Now if that same momentum strategy was tested on a diversified basket of say 25 stocks,  we could learn something about its efficacy.

Turnover   More turnover is actually good for a backtest until the turnover would begin to sensitize the backtest the execution risks and the trading costs (both commissions and slippage.)

How do I diversify out of my company?

To diversify out of the concentrated position,  you can use our free portfolio construction tool. Follow these steps:

  • Enter in your concentrated position in the legacy position table.   If your company is not publicly traded, you can enter in a publicly-traded proxy based on the same industry and other similar dynamics.
  • Be sure you correctly enter the value of your position as well as the value of your portfolio.
  • Complete the rest of the portfolio Builder,  and generate your optimization and recommendation.
  • Feel free to execute your results on your own,  with your current advisor or hire us to automate it.
  • If you don’t have us automate it, be sure to check back or turn your notifications on because diversification is a moving target.



How do I diversify out of my stock?

To diversify out of your stock you have to hold things that aren’t like it. This is mostly measured by correlation.  in other words you need to find other investments that are non-correlated or negatively correlated to your existing position.

Ideally, the positions you find should also be not correlated with each other.

This is all a bit tricky to do mentally or even an Excel spreadsheet or something.  Portfolio optimizers do a pretty good job of this.

Most portfolio optimizers use an engine called mean-variance optimization as invented by Nobel laureate Harry Markowitz.  This does a pretty good job but could also create undiversified portfolios because its primary objective of risk minimization, so we recommend a diversification optimizer.

Diversification optimization, The underlying portfolio optimization engine in Gsphere does this in a direct manner.

How do I diversify a portfolio?

Diversification is a function of both the number of assets and the degree to which those assets are independent from one another they’re both equally important but since Independence is harder to achieve it is typically the weaker Link in the process.

Typically capitalization-weighted strategies are poorly diversified.

What is a hedge fund?

A hedge fund is a  private investment partnership.  Hedge funds consist of both the general partner which is the investment manager as well as the limited partners which are the investors.  Hedge funds are regulated differently than regular mutual funds or other types of pooled investments, often using an exemption to registration.  This difference in regulation allows hedge funds to charge both a management fee as well as an incentive fee.  Hedge funds often but not always engage in hedging activities, arbitrage, short selling, futures leverage derivatives, and complex strategies.  Many of the world’s best investors operate their businesses like hedge funds.  Hedge funds might suffer from opaque disclosures as well as liquidity through lockups and are often expensive. Investors often must qualify as an accredited investor to invest in hedge funds, this is intended to protect investors especially naive investors assumed by the regulators to be smaller investors owing to the fact that more due diligence is required for successful hedge fund investing.

What is an annuity?

In annuity is an exchange aka purchase of a definite amount of money now in exchange for a series of future cash flows.  Those cash flows for the life of the annuitant.   accordingly, annuities are sold and created by life insurance companies.  There are many types of annuities such as fixed annuities variable annuities immediate annuities.  Many annuities also have writers which add certain features often are quite complex.  annuities are typically sold by insurance professionals who often receive a commission of approximately 6% of the value of the annuity.  The size of this commission is much greater than most any other product that investors might own in their portfolio leading to potential conflicts of interest in the objectivity of the advice of the insurance professional in this case often masquerading as a financial advisor or financial planner.

Should I hire a financial advisor?

A financial advisor, which in the United States is a legal term owing to one person or company owning the registered status as an investment advisor, unless subject to regulatory oversight by the securities and exchange commission or their state regulator.  If one is a financial advisor but not an investment advisor they would not be a fiduciary.  if a financial advisor is not acting in the capacity of a fiduciary, then they may have significant conflicts of interest.

Whether you should hire a financial advisor or not, depends upon your situation and psychology.

most professionals in the field of investment advice would agree that the value of financial advice is proportionally

  1. A steady hand and emotional guide which counterbalances the deleterious tendencies of investors to make emotionally charged decisions and buying and selling at the wrong times
  2. The abilities too endeavor to maximize the utility of investors money by using the correct text strategies and account formations
  3. Sitting in appropriate asset allocation
  4. Investment acumen


So generally for investors with some experience and in command of their emotions and knowing enough about the various tax strategies perhaps an investment advisor is not worth the cost of the investment advisor.

However, for most people the cost of an investment advisor is likely to be worth it especially earlier in their investment arc.

Fort do it yourself investors, with some background and trading investment advisors may not be necessary.

What is a stop loss?

Stop loss is a form of risk management which suggests that an investment would be sold if it decreased by some amount or threshold.  This would stop the loss incurred on that investment.  Stop losses are a type of order placed by investors on various exchanges, which give a conditional trigger for executing the stop loss.

Well stop losses can help investors to limit the losses incurred in a position, The obvious counterbalance is that the loss is more likely to be realized.

Stop losses are better used in low conviction investments.

It is not clear that there is any overall benefit to stop loss orders, however, when tested in concert with a systematic strategy involving rules of buying and selling an investor could get a realistic assessment of the potential benefit of a stop-loss policy on their portfolio strategy.


Also if an investor can identify the states of an economic regime,  they could backtest stop losses and have a decent chance to replicate the backtested performance provided the market conditions do not shift or jump to a new regime.

What is idiosyncratic diversification?

Idiosyncratic diversification is also known as non-systematic diversification.  This is based on the quantity of investments held.  The quantity of investments is typically the redundancy function of diversification.  This is also the type of diversification which measures concentration.  

This can be measured by examining the difference between the number of assets in a portfolio and a measure of commonality.

The two methodologies for doing this are

  1. The concentration coefficient
  2. The percentage reduction of a portfolios spanning dimension to its ambient dimension.

What is systematic diversification?

Systematic diversification involves the diversification against the commonality of the assets in the portfolio.  Typically, such commonality is measured by the correlation of those assets.  This is the extent to which assets move up or down together. 

Systematic diversification is measured by:

  1. The IPC or enter portfolio correlation, this can be expressed as a percentage, however with a nonlinear scale of utility.
  2. Systematic diversification is measured by taking the genie coefficient of a spectrum of a portfolio’s eigenvalues.

What is systemic risk?

Systemic risk is the risk enveloping the very nature of the financial markets.  Most attempts at diversification will not succeed to migrate this risk.

Is systemic risk diversifiable?

Systemic risk is diversifiable.  However, typically you have to be diversifying into less traditional assets outside of the regular construct of the ” market “.  

Academics might not feel that systematic risk is diversifiable this is typically just a function of their limited perspective that the market contains all things while practitioners know that the market is typically thought of as the stock market and there are many investments and strategies that are outside of the stock market whether in exposure, physical or ecological location.

How do you measure risk?

Risk is losing money.   unfortunately, a precise measure of risk can only be known after the fact, or what quants call ex-post.

The risk may be estimated in many ways.  Each risk estimation has its own fallibilities.

The most prevalent risk estimation is a measure of variance.  Variance is the extent to which asset prices deviate from the mean, when expressed as a percentage this is called the standard deviation.  

Variance standard deviation and volatility are all expressing the same thing.  However typically variance and standard deviation are used for prediction or estimation, volatility is usually a realized value based on the implied volatility of options prices.  This is what gives rise to the Vix volatility index.

other risk measurements tend to be of superior predictive value as measured by their auto correlations

Other risk measurements include:

  • Maximum drawdown
  • Ulcer index
  • Downside deviation
  • Value at risk
  • Estimated tail loss

What is Smart beta?

To understand smart beta let’s first make sure we understand beta. 

A regression equation has an alpha and a beta.

The regression is used to study the relationship between two things, in the cases investment betas are used to measure the relationship between an asset or a portfolio and typically a benchmark or index.  

The regression or beta is the slope of the relationships of the least squares line of each plot of asset prices.  

The alpha is the intercept on this equation which an investment parlance is an amount of returns that is provided by the investment completely unrelated to that of the index or benchmark.  

Beta is easy to get and can be purchased by index funds for just several basis points. 

Alpha is hard to obtain, hard for most investment managers to produce on a consistent basis, and very valuable when it can be demonstrated.

Smart beta thus refers to a body of typically alternative index-based approaches where those approaches are often varying by the weights in which index constituents are assigned.

Smart beta may also be related to potential filters or screens.

The term is viewed pretty loosely and investors would be wise to not assume that there was anything smart about it, despite the best intentions of the manufacturers of smart beta products.

Smart being a product may exist as an exchange-traded fund, index mutual fund or managed account.

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