Fool’s Gold, from Russ Herrold

November 25, 2013 |

 I came across about this rather nice summary of backtesting in the context of investment/trading framing over the weekend.

"Fool's Gold:Why most back-tested performance histories are bunk, and how you can identify the ones that probably aren't" :

Reasonable investors derisive of back-tests acknowledge that in theory back-tests can illuminate something true about the world but believe in practice back-tests can rarely be relied on to do so. The Vanguard study, by finding that past performance does not reliably predict future returns of asset classes, joins a chorus of studies by many independent researchers demonstrating the same. A skeptic might conclude back-tests are to induction what Richard Simmons' hair is to the category of things that can be burned for fuel.

The problem with that argument is too many successful investors are or were back-testers. Benjamin Graham, father of value investing and Warren Buffett's mentor, devised trading rules based on studies of what would have worked in the past–back-tests, in other words. Early in his career, Buffett applied Graham's back-tested rules to identify "cigar butts," statistically cheap stocks that had assets that could be sold for more than they could be bought for. Another successful Graham acolyte, Walter Schloss, achieved 20% gross annualized returns over several decades by "selecting securities by certain simple statistical methods…learned while working for Ben Graham." 

Ray Dalio, founder of Bridgewater Associates and arguably the most successful macro investor alive, uses back-tested strategies to run Pure Alpha, an unusual fund that uses only fundamental quant models. Mathematician James Simon's Medallion Fund, a quantitative, fast-trading strategy, has earned 35% annualized returns after fees since 1989.

Jeff Rollert adds:

The difference between back testing and understanding drift is the difference between knowing history as taught and understanding evolution.

That is my inner Hobbes speaking today.


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