Backtesting

33 Pages Posted: 16 May 2015 Last revised: 5 Jul 2015

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; Lawrence Berkeley National Laboratory; RCC - Harvard University

Date Written: May 14, 2015

Abstract

Empirical Finance is in crisis: Our most important "discovery" tool is historical simulation, and yet, most backtests published in leading Financial journals are flawed.

The problem is well-known to professional organizations of Statisticians and Mathematicians, who have publicly criticized the misuse of mathematical tools among Finance researchers. In particular, reported results are not corrected for multiple testing. To this day, standard Econometrics textbooks seem oblivious to the issue of multiple testing. This may invalidate a large portion of the work done over the past 70 years.

We present practical solutions to this problem.

This presentation is related to papers http://ssrn.com/abstract=2308659, http://ssrn.com/abstract=2326253, http://ssrn.com/abstract=2460551, http://ssrn.com/abstract=2507040 and http://ssrn.com/abstract=2597421.

Keywords: backtest, historical simulation, probability of backtest over-fitting, investment strategy, optimization, Sharpe ratio, minimum backtest length, performance degradation

JEL Classification: G0, G1, G2, G15, G24, E44

Suggested Citation

Lopez de Prado, Marcos, Backtesting (May 14, 2015). Available at SSRN: https://ssrn.com/abstract=2606462 or http://dx.doi.org/10.2139/ssrn.2606462

Marcos López de Prado (Contact Author)

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.lbl.gov

RCC - Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

HOME PAGE: http://www.rcc.harvard.edu

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