One of the most important tools in an investor’s toolbox, for testing investment strategies, is that of back-testing.
Once we find an investing strategy that makes intuitive, logical sense, we test it to see how it has performed in the past to identify key information that can be used to predict how it will perform in the future.
Like any tool, the results will reflect on how well you understand the tool and its limitations. Back-testing will tell you some general, overall statistics about a strategy, but will only be part of the picture. It is the details you want to understand. Put another way, in investing, “there is back-testing, and then there is back-testing”.
Garbage In = Garbage Out
Most, if not all, investors hold an opinion on how best to invest. That’s not a problem, it’s still a free country after all. How many of us though do the work required to have an opinion? The work is the hard part, that’s why people avoid it. You must…
- do the reading,
- talk to anyone competent you can find and listen to their arguments,
- think about the key variables and how they interact,
- listen and chase down arguments that run counter to your views,
- think about how you might be fooling yourself,
- see the potential risk through multiple lenses, and
- become your most intelligent critic and have the intellectual honesty to kill some of your best-loved ideas.
In short, you need to do the work in order to ensure your back-test is not simply a confirmation bias tool, and that sucks because it’s time consuming and hard. Doing the work counteracts our natural desire to seek out only information that confirms what we believe we know.
But past performance doesn’t guarantee future success.
We’ve all heard this disclaimer but the point I’m trying to make is that rather than making potentially faulty assumptions about the future, we should stick to the only real data we have; market history.
To determine the viability of an investment strategy, check to see how frequently it would have worked in the past. If one accepts that investing is about probabilities and not guarantees, then surely the fewer assumptions you make, the more well-founded your conclusions will be.
I still hear you shouting at me and saying the future won’t look exactly like the past. The fact that an investment strategy has not worked historically may be a sufficient reason not to count on it to work in the future. But the fact that a strategy has worked in the past isn’t sufficient evidence that it will work in the future.
When you have the benefit of hindsight (and the computing power and data to back-test any strategy you can come up with), there are an infinite number of investment strategies that will have succeeded based on nothing other than randomness.
I hear your argument and raise you one common sense.
Unfortunately, there is no such thing as a front-test. Every market environment is different than the last so you must be able to accept that the future will never look exactly like your time-tested strategy. It is for this reason that one must use the full arsenal of investment tools available to them.
- Diversifying across asset classes, geography, currency and fund manager helps to reduce risk,
- Reducing investment costs helps to increase investment return, and
- Given enough time, good markets will create wealth.
A common error identified in behavioural research on the stock market is this tendency to generalise. Do the work, be open to being wrong and have patience.
“We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.” — Charlie Munger