What is back testing?

Back testing is an important tool

used by "technical" market analysts

With the introduction of personal computers, the science of “technical analysis” of market behavior became broadly available for the first time. At first, its primary appeal was with commodity traders in Chicago and at the stock exchange in New York.

During the past decade, the science migrated into the world of longer-term investing. It turns out that some of the techniques used effectively by commodity traders and day traders also work well when applied to longer-term market trend analysis and stock market investing. And new approaches have developed that apply strictly to longer-term investing.

Today there are many software platforms available for technical analysis with varying degrees of sophistication. While many in the public remain unfamiliar with technical analysis and how it differs from the traditional investment approach known as “fundamental analysis,” the sub-culture of computer-oriented “market technicians” steadily grows and the number of investment newsletters and diversified investment advisors using technical analysis increases.

What is back testing?

The mathematical basis of technical analysis allows you to reduce a trading strategy to a formula. The formula simply describes the logic of the trading strategy. Of course, the trading strategy must be based upon variables that can be quantified and tracked over time. Then, a computer can be used to run the strategy’s logic against an historical data series.

• The computer tracks the decisions made by the mathematical logic, conducts hypothetical “buys” and “sells” of the subject investment, and then tallies up the results.

This is back testing. The computer allows you to test any number of variables and any number of alternative approaches quickly and easily to develop an effective market timing strategy.

And, once you have established an effective strategy, you can use back testing to simulate its performance over previous, historical periods. 

Back testing helps design new strategies

If you had a theory for a trading strategy or longer-term investment strategy, it would be nice to be able to test that theory over past market history rather than having to try it out “live” to see whether it works or not. Testing the theory using back testing would certainly be much more time-efficient and less costly.

• Most “strategists” and market pundits on Wall Street never test the investment advice or stock market tips they so readily offer. Anxious investors eat up their “expert” advice without much reflection on whether any rigorous historical testing is behind it.

In sharp contrast, market technicians use technical analysis to build sound market timing strategies based upon solid statistical relationships in the markets – patterns and relationships that tend to repeat themselves with a reasonably high statistical frequency ... certainly with enough frequency to gain a systematic “edge.”