DocServer

PSEUDO-MATHEMATICS AND FINANCIAL CHARLATANISM: THE EFFECTS OF BACKTEST OVERFITTING ON OUT-OF-SAMPLE PERFORMANCE

Bailey, David H. and Borwein, Jonathan M. and de Pardo, Lopez M. and Zhu, Qiji J. (2014) PSEUDO-MATHEMATICS AND FINANCIAL CHARLATANISM: THE EFFECTS OF BACKTEST OVERFITTING ON OUT-OF-SAMPLE PERFORMANCE. Notices of the AMS (61). pp. 458-471.

[img]
Preview
PDF - Accepted Version
Download (4Mb) | Preview

    Abstract

    Recent computational advances allow investment managers to methodically search through thousands or even millions of potential options for a pro�table investment strategy. In many instances, the resulting strategy involves a pseudo-mathematical argument, which is spuriously validated through a simulation of its historical performance (also called backtest). We prove that high performance is easily achievable after backtesting a relatively small number of alternative strategy con�gurations, a practice we denote \backtest over�tting." The higher the number of con�gurations tried, the greater is the probability that the backtest is over�t. Because �nancial analysts rarely report the number of con�gurations tried for a given backtest, investors cannot evaluate the degree of over�tting in most investment claims and analysis. The implication is that investors can be easily misled into allocating capital to strategies that appear to be mathematically sound and empirically supported by a backtest. This practice is particularly pernicious, because due to the nature of �nancial time series, backtest over�tting has a detrimental e�ect on the strategy's future performance.

    Item Type: Article
    Subjects: UNSPECIFIED
    Faculty: UNSPECIFIED
    Depositing User: Mrs Naghmana Tehseen
    Date Deposited: 06 Jan 2015 10:12
    Last Modified: 06 Jan 2015 10:12
    URI: https://docserver.carma.newcastle.edu.au/id/eprint/1506

    Actions (login required)

    View Item