Backtest Overfitting in Financial Markets

Abstract

We introduce two online backtest overfitting tools: BODT simulates the overfitting of seasonal strategies (typical of technical analysis), and TMST simulates the overfitting of econometric strategies (typical of academic journals). We show that econometric methods lend themselves to extreme levels of overfitting, casting doubt on most investment strategies published in academic journals.

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