Stock Portfolio Design and Backtest Overfitting

16 Pages Posted: 29 Feb 2016 Last revised: 20 Jul 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

Date Written: July 19, 2016

Abstract

We demonstrate a computer program that designs a portfolio consisting of common securities, such as the constituents of the S&P 500 index, that achieves any desired profile via in-sample backtest optimization. Unfortunately, the program also shows that these portfolios typically perform erratically on more recent, out-of-sample data, which is symptomatic of selection bias. One implication of these results is that so-called smart beta funds, which are designed in-sample to deliver a desirable performance pro file, are likely to disappoint out-of-sample.

Keywords: backtest, historical simulation, probability of backtest overfitting, 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, Stock Portfolio Design and Backtest Overfitting (July 19, 2016). Available at SSRN: https://ssrn.com/abstract=2739335 or http://dx.doi.org/10.2139/ssrn.2739335

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

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