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Why is back-testing so unreliable?

Back-testing is a type of analysis that is commonly used by quantitative investors to evaluate the performance of a trading strategy. In back-testing, a trader will use historical data to test a trading strategy and see how it would have performed in the past. Whilst back-testing can be a useful tool for evaluating a trading strategy, it is not without its limitations and can be unreliable in some cases.

One of the main reasons why back-testing is unreliable is that it is based on historical data. Whilst historical data can provide valuable insights into market behaviour, it is not always an accurate predictor of future performance. Market conditions are constantly changing, and what worked in the past may not work in the future. As a result, back-testing may not provide a reliable indication of how a trading strategy will perform in the future.

Additionally, back-testing is subject to certain biases and limitations. For example, back-testing is typically performed on a limited amount of data, which can be affected by a number of factors such as sample size and data quality. If the data used in the back-test is not representative of the broader market, the results of the back-test may be inaccurate.

Furthermore, back-testing can be subject to overfitting, which occurs when a trading strategy is optimised to fit the historical data too closely. Overfitting can lead to unrealistic results in the back-test, as the strategy may not be able to perform as well in real-world market conditions.

In conclusion, whilst back-testing can be a useful tool for evaluating trading strategies, it is not without its limitations and can be unreliable in some cases. Investors should be cautious when using back-testing and should consider other factors, such as forward-testing and risk management, when evaluating a trading strategy. It is always important to do your own research and seek professional advice before making any investment decisions.

“It’s not supposed to be easy. Anyone who finds it easy is stupid.” – Charlie Munger

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