What is Back Testing?

Back testing is a trading strategy that involves the task of analyzing historical data related to the investment opportunity. The results of the investigation are then compared to the current status of the investment. This is to determine if there are any indications of favorable trends. Here is some information about how back testing works, why it is important to work with accurate data, and what can happen if the back testing is conducted improperly.

One of the key things to understand about back testing is that the process relies a great deal on running simulations. While is it not unusual for any investment to be ran through a series of simulations based on the number of shares bought or sold, the concept goes a little deeper with back testing. Not only are simulations run based on the current status of the stock or share performance; simulations are also run on the past performance of the investment. This extra mile of predicting trading cycles and performance levels based on past status is then applied to the current status of the investment.

The point of back testing is to see if there were similar sets of circumstances in the past that are applicable to the current state of the investment. If so, this may be a strong indicator of where the investment is likely to move in the future. This is especially true if the combination of past data and simulations indicates the investment has been at a similar state on a number of occasions in the past, and tended to move in one particular direction in a majority of the simulations.

One of the dangers with conducting back testing is that the reliability of the results is directly related to the quality of the historical data used to run the trade simulations. Incorrect or incomplete data will quick render any attempt at back testing worthless. Also, it is important to not disregard any aspect of the past performance of the investment, even it the detail may seem innocuous. The more complete and detailed the data used to conduct the back testing, the better chances that the simulations will point to a viable conclusion about how the investment will trade in the future.

Back testing is not an exercise that can be conducted in five minutes or less. Also, the amount of detail that must be applied can be extensive. For persons who want a quick answer and are not interested in wading through the past documentation on the performance level, back testing may seem like a great deal of trouble for very little return. Still, in the event of making a major investment, taking the time to engage in back testing is one way of ensuring that the investment is a sound one, and likely to grow in the future.