Backtest Overfitting in Financial Markets

Automated Trader, 2016, Forthcoming

8 Pages Posted: 15 Feb 2016

See all articles by David H. Bailey

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Jonathan Borwein

Royal Society of Canada; University of Newcastle (Australia); Australian Academy of Science (deceased)

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; Abu Dhabi Investment Authority; True Positive Technologies

Amir Salehipour

University of Technology Sydney, Australia; University of Technology Sydney (UTS)

Qiji Jim Zhu

Western Michigan University

Date Written: February 9, 2016

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

Suggested Citation

Bailey, David H. and Borwein, Jonathan and Borwein, Jonathan and López de Prado, Marcos and López de Prado, Marcos and Salehipour, Amir and Salehipour, Amir and Zhu, Qiji Jim, Backtest Overfitting in Financial Markets (February 9, 2016). Automated Trader, 2016, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2731886

David H. Bailey

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.davidhbailey.com

University of California, Davis ( email )

One Shields Avenue
Apt 153
Davis, CA 95616
United States

HOME PAGE: http://www.davidhbailey.com

Jonathan Borwein

Royal Society of Canada

University of Newcastle (Australia)

Australian Academy of Science (deceased)

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

Abu Dhabi Investment Authority ( email )

211 Corniche Road
Abu Dhabi, Abu Dhabi PO Box3600
United Arab Emirates

HOME PAGE: http://www.adia.ae

True Positive Technologies ( email )

NY
United States

HOME PAGE: http://www.truepositive.com

Amir Salehipour

University of Technology Sydney (UTS) ( email )

15 Broadway, Ultimo
PO Box 123
Sydney, NSW 2007
Australia

University of Technology Sydney, Australia ( email )

Ultimo
Ultimo, NSW 2007
Australia

Qiji Jim Zhu

Western Michigan University ( email )

Kalamazoo, MI 49008
United States

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