Learning Through Portfolio Backtesting - The Short-Term Isn't That Meaningful

Jun 10, 2012 in Backtest

In this post, we will check back in on the 'Sample Portfolio' -- which was a portfolio we set up over 2 years ago and included as the starter example portfolio for new members.   The idea behind it was to show one type of simple mix of ETFs that can serve as good complements to each other in terms of a rotation strategy.

As seen below,  this rotation portfolio has performed pretty well over the past 2 years.   

But the more specific point we wanted to make here was in the statistical profile that accompanies the report (marked with an arrow at the bottom).  

In the last 'out of sample' 18 monthly results (2011 & 2012), while this strategy is well ahead of the major indexes -- it has actually underperformed the S&P 500 in 10 out of 18 of those months.   Yes, that is right --  it has handily beat the S&P 500 on a cumulative basis while still underperforming more times than not in terms of months.  That seems counter-intuitive -- but this actually isn't that unusual in investing.  

Many times you run a backtest and it shows good results --- make sure to scan down to that number in the table below and take a look at how often is outperforms your inputted benchmark.  If you do this a lot, you will start to understand some of the common pitfalls of bahavioral finance issues.

This is the important part --- if you didn't know this, imagine how your psychology might affect your investing process.  The start to 2012 is a good example.  Our allocations board portfolio fell behind the S&P 500 return on a Year-To-Date basis in March (relative basis only).   Was this underperformance meaningful?  No.  Not if we believe that our strategy is solid and that we don't care about the short-run --- we only care about the equity curve over time.  Through backtesting, we are armed with the knowledge that good strategies might indeed underperform in 40% or more of the months and this does nothing to change the validity of the strategy.

Summary:   We all want to outperform the indexes in every single period --- but if you obsess about this kind of thing --- chasing a benchmark around in every short-term timeframe -- it will ultimately be your un-doing.   The behavioral/mental side of investing is hugely underrated.   The specific numbers in this one example are not the point.   The point here is to use the portfolio backtesting process as a way to battle against the behavioral biases that keep you from doing well in investing.   In our view, backtesting ideas can greatly help because if you are like us, you have to SEE it and imprint it on your brain to actually believe it.  Only through a good and never-ending research process will we ever truly believe in these kinds of things.


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Jun 10, 2012 15:56 #

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Chris United States

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