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Stock Portfolio Design and Backtest Overfitting

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

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Jonathan M. Borwein

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

Marcos Lopez de Prado

Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC

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 M. and Lopez 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
Davis, CA 95616
United States

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

Jonathan M. 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 Lopez de Prado (Contact Author)

Guggenheim Partners, LLC ( email )

330 Madison Avenue
New York, NY 10017
United States

HOME PAGE: http://www.QuantResearch.org

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

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

Harvard University - RCC ( email )

26 Trowbridge Street
Cambridge, MA 02138
United States

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

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