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Portfolio Backtesting: How to Do It and Why Not to Trust It Blindly

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Key takeaways

A backtest is a historical simulation of portfolio performance — it shows how a strategy would have performed in the past, given certain rules. It's a valuable but easily misused tool.

What a Backtest Is For

Used correctly, a backtest helps you:

What a backtest is not for: predicting future returns, or choosing a strategy simply because it had the best historical performance.

Three Big Traps

Survivorship bias — historical databases primarily contain companies and funds that survived. Failed businesses are missing, so average returns are inflated.

Data mining and overfitting — if you test 100 different strategies on the same historical data, statistically you'll find several that work — purely by chance. A strategy fitted to a specific history doesn't work in the future.

Look-ahead bias — in the backtest model you unintentionally use information that wasn't yet available at the time (e.g. today's dividend data applied retroactively).

Golden rule: The more you've optimised the strategy's parameters to history, the less you should trust the backtest result.

How to Backtest Properly

Include all real costs — fees, spreads, dividend withholding taxes. Test over the longest possible history covering different market cycles (bull market, bear market, sideways market, inflationary and deflationary environments). Use out-of-sample validation — test the strategy on a different time period from the one on which you designed it.

Practical Use

For the average investor, backtests are freely available on tools like Portfolio Visualizer or Backtest.curvo.eu. They help verify the basic characteristics of a portfolio — but not to pick the "best" strategy. We discuss factors that backtests don't easily capture in the article on factor investing and on why not to forecast markets.

FAQ

What is a portfolio backtest?

A historical simulation showing how a portfolio would have performed in the past under given rules — allocation, rebalancing, contributions. It's useful for understanding the strategy's volatility and drawdowns, but does not guarantee future returns.

What is survivorship bias?

A distortion in historical data: companies and funds that went bankrupt or ceased to exist are missing from databases. The result is that historical average returns are inflated by the survivors — better than investors actually experienced at the time.

How do I run a reliable backtest?

Include real fees and taxes, test over the longest possible history covering different market phases, and avoid optimising too many parameters. If possible, validate the strategy on a different time period from the one on which you designed it.

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