In the arsenal of sales tools the finance industry uses, the backtest is surely one of the most paradoxical.
Investopedia defines backtesting as “the process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital.” Essentially, it’s a simulation of the past with the added benefit of hindsight bias. Jason Zweig in The Devil’s Financial Dictionary, is more acerbic, if not accurate, with his definition:
Backtest, v. and n. To comb through financial databases to determine which investing strategy would have worked the best if anyone had known about them at the time. Many asset managers then use the backtest as a way to extract money from clients in the present—and disappoint them in the future.
Backtesting is placing the bet after the race. This is, perhaps, a little unfair as backtesting has the potential to yield interesting, if not always useful, insights. Still, much depends on the quality of the backtest and, particularly, its timeframe. The self-selective nature of backtests means that one tends to hear a lot more about investing strategies that worked under certain parameters and specific timeframes than those that didn’t. In this way, the backtest offers little in the way of learning for the new investor.1
Might then I propose the concept of forward-testing, wherein you take a past prediction and see how it actually performed.2