MARKET COMMENT
Why Back-Testing Is Important
By David Kuo (TMFDragon)
November 28, 2001
Carburton Street, London -- What is back-testing? No, it's not some form of physical torture to see if your neck and spine will stand up to the stresses and strains of a rigorous gymnastic workout. It is a scientific approach to determine whether your investment strategies hold water before you start to invest with real money. For example, we at the Fool maintain that a well-diversified portfolio of stocks (or an index tracker) should outperform other forms of investment. These other investments might include bank deposits or Governments Gilts. Simple back-testing of the assertion shows that this has indeed been the case.
Some investors might prefer something a bit more risqué, say an investment in the drug or bank sectors. How much better off would investors be by investing in the drug sector, say, when compared with an All-Share Index tracker? Again you need to go back into the history books and dig out some information on the FTSE All-Share Pharmaceutical sector over a period of time. The FTSE website provides information covering the last few months. Additional historical data can be obtained, but at a cost. By comparing various scenarios, you can soon develop a feel for the sector and the kind of risks that might be involved. Some charting features allow you to compare individual shares to indices and industry sectors.
Back-testing can help investors establish what they can expect from their investments. You can't assume that the future will follow the same pattern but it can reveal a level of volatility or risk, which some investors might feel is unacceptable. Without a well-reasoned and rational investment strategy it is almost impossible to make reasonable and rational decisions about investing. A well-researched and properly back-tested approach can uncover shortcomings in the investment strategies but surely it is better to find out with a paper portfolio than with real money -- because it's too late once you've lost a huge chunk of capital.
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