How Does Backtesting Your Investment Strategy Work?

Whether you’re new to investing or looking for a more successful strategy, backtesting is a good way to reduce your risk and help make more informed decisions.

If you haven’t heard of this strategy before, this article will help you understand this type of option and run through what it is, how it works, and the benefits and risks.

What is Backtesting?

When it comes to making investment decisions, having as much data as possible will provide important information for getting results.

This is what backtesting does, it takes the historical, real data from previous trading strategies to suggest how well the strategy will perform today.

It will show what companies are best suited to your investment strategy and their previous performance.

You can backtest using the values, ratios, and indicators of previous data to help inform your decision.

Why Backtest?

With backtesting, you can use historical behaviour and data to determine the likelihood of its profitability.

This means that if the results show a high return and low risk, it’ll provide the investor with more confidence that the strategy will perform well.

This is because backtesting is based on the idea that if a previous strategy was high-performing then it is likely to perform well in the future.

It’s not only helpful for suggesting which strategies to go for, but also which strategies to avoid. This is because strategies which have performed badly in the past aren’t likely to perform well in the future.

Backtesting can also provide key information surrounding certain moments in history, such as COVID-19. This can be helpful for investors as they can use this data and information to predict how their stocks and investments may do in future global incidents, understanding how much they will potentially lose during this time.

Can All Investment Strategies Be Backtested?

If an investment strategy uses a set of rules then there is no reason why it can’t be backtested. 

By using strategies that follow a set of rules, using historical data is easy. The main benefit is that the use of data can remove the emotional element of making investment decisions, instead basing them on logic and historical evidence.

The main advantage to this is it will stop investments from being made due to panic or the fear of missing out on an opportunity.

Tips to Backtest Successfully

To give yourself the best chance of finding out how successful your investment strategy can be, you need to make the backtest realistic. The following tips will help increase these chances. 

Backtest By At Least 15 Years

The longer your backtest period, the more data you’ll be able to use to inform your decision. This will also cover any large financial crisis like the one in 2008 and will help you understand how much the strategy would lose if another crisis took place.

The More Stocks the Better

If you have more than 100 stocks in an investment universe, you’re able to test whether the strategy can result in winning sticks from a big batch. The smaller number of stocks means it’s harder to see if the strategy works.

Include No Less Than 20 Stocks

The more stocks you have in your portfolio, the less likely a single stock will impact your overall performance. This will reduce the scenario that your stock just got ‘lucky’. With a diverse portfolio, you can be more certain that the strategy is able to find successful stocks.

Don’t Forget Transaction Costs

When you create a backtest, you should include the broker’s transaction costs. This is because as your transactions increase, so will the transaction cost. This will eventually impact your returns and should be included to provide the most realistic data about how much money the strategy has made overall.

Understand Your Strategy with Backtesting

To truly understand your investment strategy, backtesting can help you determine how effective it can be by analyzing its historical behaviour.

It’s also helpful when looking at certain moments and events in history to predict how the strategy would be impacted if anything similar takes place in the future.

Following evidence instead of making decisions based on emotion or a sense of urgency is another reason why backtesting can provide more successful investment returns.

Interesting Related Article: “A Guide to Investing During a Recession