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BACKTESTING AND SIMULATION - Coggle Diagram
BACKTESTING AND SIMULATION
Backtesting
Objective
The primary goal of backtesting is to assess the risk and return of an investment strategy by simulating the investment process
Process
Strategy design
The first step is to identify the investment goals and hypothesis.
Investment universe
Specific definition of returns
Frequency of portfolio rebalancing
Start and end dates
Historical investment simulation
• Form investment portfolios for each period according to the rules specified in the previous step
• Rebalance the portfolio periodically based on predetermined rules
Analysis backtest output
• Calculate portfolio performance statistics
• Compute other key metrics (e.g., turnover, etc.)
Common problems
Survivorship bias
Look-ahead bias
Data snooping (p-hacking)
The act of testing multiple investment models and selecting the best-performing one based on statistical results rather than solid theoretical foundations, often leading to a higher risk of false-positive outcomes.
solution
t-statistic
Cross validation
Historical scenario analysis
A form of backtesting where we investigate the risk and return of an investment strategy during various regimes, while taking into consideration the various structural breaks that are present.
Recession versus expansions
Low- and high-volatility periods
Interpret metrics and visuals reported in a backtest of an investment strategy
Value at Risk (VaR)
Conditional VaR
Maximum drawdow
Visuals
Sensitivity analysis