Source: Wealth Creator Magazine Sep/Oct 2006

Back testing on the stockmarket

In the Stockmarket I can 'Back test' any share trading strategy that I am interested in and, by testing and measuring its outcomes on paper, I can validate and optimise its performance before committing cash to it.
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Trading shares is a business

Source: Wealth Creator Magazine Sep/Oct 2006

Back Testing

Trading shares is a business like any other and, as with any business, it pays to investigate its financial viability before committing capital. I am often horrified by the conservative thinking that has the average 'Mum and Dad' business partners committing the family nest egg to a commonplace retail business that sells tangible goods (i.e. a Newsagency) without any proper investigation. On the other hand, they would never consider share trading to be a viable type of business. Their logic behind blindly pursuing a 'garden variety' retail business is that it must be a viable business strategy if there are so many other people out there doing it already.

What they don't know is that all those other people applied similar reasoning and now they are all working 50 to 60 hours per week to keep the taxman and their bank managers happy.

Whilst running the risk of stating the obvious, share prices move without my being present, making share trading a valid 'Business' proposition. But here's the best part: I can assess the financial viability of any share trading strategy by using historical data and without risking a single cent. In the Stockmarket I can 'Back test' any share trading strategy that I am interested in and, by testing and measuring its outcomes on paper, I can validate and optimise its performance before committing cash to it.

This poses an obvious question

With this supposedly foolproof approach to 'proving' share trading strategies, why do so many people lose money in the Stockmarket?

Answer

Share trading to the majority is about individual shares and not about the strategy they employ.

What's more, most people who do employ a market strategy will clearly put individual shares ahead of their strategy by 'tweaking' the latter so they will own the shares of their desire. However, this type of fool's paradise would be virtually impossible to achieve if they performed thorough back testing. When back testing, the focus is on the performance of your entire portfolio over an entire year and therefore the behaviour of individual shares is of little interest. But we are emotional creatures who can become attached to a share that has rewarded us over time. So, while emotional detachment makes good commonsense, it's easier said than done. Here, we again see the benefit of back testing because our ultimate loyalty lies with my bank account and we will sever our emotional connection with individual shares for the sake of nurturing our monthly bank statement.
Once we have our focus squarely adjusted onto our trading strategy and we are committed to the process of back testing, we must be ready to 'test and measure' outcomes. In other words it's vital that we have and maintain a trading ledger or we quickly collapse into a disorganised mess.

Another general benefit of back testing is the practice that we gain from it. Unfortunately the providers of modern charting programs would deny us this benefit. Not only does automated back testing ignore the fact that most of us could do with the practice but it doesn't usually work because our strategy includes some form of qualitative analysis.

Although I am a devout user of Supercharts I find its automated functionality to be quite comical.

The last important point to be made about back testing is the need to keep it relevant. There is little point in using historical data from anything further back than three-to-five years as it is largely irrelevant to current market conditions.

Financial markets evolve over time and the Australian Stockmarket is no exception. We participated in the Tech boom of the 1990s and enjoyed a significant bull run from March 2003. These are key features in our Stockmarket's history and to employ data from before these events is to run the risk of being irrelevant.

 

Written by


Alan Hull is a second generation share trader. He conducts regular seminars  on trading and is a member of the Australian Technical Analysts Association. Alan has managed tens of Millions of dollars of other people’s retirement funds, his performance beating all the major ASX market averages. 
www.alanhull.com.au