Why Do a Back-test?

First, what is a back-test? A back-test is going back in time to evaluate an investment strategy that you think can provide returns greater than the broad market as defined by the S&P 500 or another popular index. There are software programs out there that allow you to back-test a strategy. However, if you have the programming skills and access to the necessary database you can write your own code to accomplish what you need. So, why go through the trouble? You do not want to do something that does not yield the results that you expect, and other investors interested in your strategy might require proof that a strategy worked in the past. Of course, past performance is no guarantee of future results but nonetheless a back-test is a necessity. However, for those who already know that their investment strategy works, why do a back-test?

Typically, when an investor develops a strategy, they use screening software to find the stocks with the desired characteristics that drive investment outperformance against a particular benchmark like the S&P 500. Therefore, for professional investors a back-test should be mandatory as it can lead to new discoveries, and it will nail down exactly what is driving your portfolio’s investment performance. The more you know about what drives performance the more you can focus on the process that selects the stocks with the desired characteristics to add to your portfolio. Additionally, running a back-test can also help you choose the optimal number of stocks to include if that is a requirement for your portfolio.

If the back-test is a success and yields impressive results, then an investor could run the screen periodically to get new stock ideas when it is time to pick a new set of stocks. Sounds easy but unfortunately finding the right strategy that outperforms the market over time requires a great deal of effort. Assume that you have a strategy, as we do here at Investoristics, that works very well historically and presently. Could you then blindly run the screening software monthly, quarterly, or annually and reinvest on the desired basis? Sure, but doing that might not be optimal although it certainly takes the emotional element out of the investment process. The following is what happened when we blindly ran our strategy over the past 18 years.

As you can see from the statistical presentation of the back-test results, we handily outperformed the index over the period. Most would be happy with these results but knowing what fundamental characteristics the portfolio needs to deliver this kind of performance is an advantage which allows us to optimize the stock selection process. Fortunately, there are still things to do at the individual stock level to further enhance performance. The back-tested results are purely quantitative which means we never considered unwelcome news, mergers or acquisitions, risk management strategies and accepted any large losses. Also, we did not kick out stocks that we felt were too expensive although a value standard was a necessary component in the screening process. Based on experience, at Investoristics we do not believe that an annual holding period is optimal, but it can be effective as you can see from the graphical presentation above.

So, what if we addressed the issues that a blind back-test did not address? The statistical presentation would show a more dramatic outperformance against the S&P 500. Also, we would have a stronger process that would optimize our stock picks. The optimized process would ensure that we are not picking overvalued stocks, that we have more than adequate risk management measures in place, and finally, that we have the best rebalance interval. As an individual investor, you have all the tools available to find a winning strategy but if you do not have the time then join “The Collective.”