Backtesting an Investment Strategy

Backtesting is an investment strategy evaluation technique. It uses past data to test real-life investment processes to assess whether a strategy would yield desirable outcomes.

Objectives of Backtesting

• Backtesting offers investment strategy-related rigor and insight to investors.
• Backtesting is used as an approval or rejection criterion for an investment strategy. Fund managers, for example, always accept an investment strategy that shows positive results upon backtesting.
• Backtesting is a tool for fundamental analysis to determine the historical efficacy of an investment strategy.

One thing to note is that while we assume that backtesting will somehow reflect the past, the reality is that randomness in the future can change the results.

Question

Which one of the following is least likely to be a reason for backtesting an investment strategy?

1. To offer insight into an investment strategy.
2. It is used to value stocks.
3. An investment strategy approval or rejection criterion.

Solution

The correct answer is B.

Backtesting only uses past data to evaluate how well an investment strategy would perform.  As such, it cannot be used as a valuation tool.

A is correct. Backtesting offers investment strategy-related rigor and insight to investors.

C is correct. Backtesting is an approval or rejection criterion for investment strategies where strategies with negative outcomes are rejected while those with positive outcomes are approved.

Reading 42: Backtesting and Simulation

LOS 42 (a) Describe objectives in backtesting an investment strategy