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

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

Marcos Lopez de Prado

AQR Capital Management, LLC; Cornell University - Operations Research & Industrial Engineering; RCC - Harvard University

Amir Salehipour

University of Technology Sydney, Australia

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 López de Prado, Marcos 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
Davis, CA 95616
United States

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

Jonathan Borwein

University of Newcastle (Australia) ( email )

University Drive
Callaghan, NSW 2308
Australia
+61 2 4921 5535 (Phone)

HOME PAGE: http://www.carma.newcastle.edu.au/jon

Royal Society of Canada ( email )

282 Somerset West
Ottawa, Ontario K2P 0J6
Canada

Australian Academy of Science ( email )

Ian Potter House
Gordon Street
Acton, ACT 2601
Australia

Marcos López de Prado (Contact Author)

AQR Capital Management, LLC ( email )

One Greenwich Plaza
Greenwich, CT 06830
United States

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

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

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

RCC - Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

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

Amir Salehipour

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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