What is Back Testing?

Back testing is a common tactic used in the investing world. It’s almost always used by sales people to show prospective clients the benefits of signing up for a certain kind of investment or a certain kind of market timing.

I talk about tactical asset allocation all the time. This is the term given to the practice of moving your portfolio around from one sector to another—small companies to large companies, for example—because it is believed that large companies will out earn small in the upcoming period. This is also referred to as trend following, absolute return, or sector rotation.  Back testing is often used to lend credibility to a short-term run of good luck.

The key to making this work is finding behavioral patterns in the historical data that would have netted investors a return. That pattern is then watched. If it works for a while, let’s say a year or two, then the money manager has something salable. The sales pitch is this: If you had been in this system for the past 7 or 8 years, you would have made 21% returns (that’s a big if, considering no one actually received those results). Some programs will not even run any actual tests before they start selling the investment. This sales technique works in any kind of market, up, down or sideways, because given enough data, it’s possible to find a way to have gained a return and to identify patterns within that data.

The problem with this method of investing is that it’s not really a method of investing at all. It sometimes works for a couple of years, but invariably the trend stops. Once the trend stops a new trend is found and the investors are convinced to jump on again. But the trends never continue long enough for investors to achieve the gains they were sold on.

Its “truth” is in the if/then statement. If you would have done this, then you would have had that return. On its face, the statement may be true, but few if any investors can actually say they achieved the returns. The practice is deceptive at best.

This kind of offering by financial planners could be a big source of your anxiety in the coming months and years unless you recognize it for what it is. You see, you made it through 2008 and 2009 without a scratch. And yet, if you are still licking your wounds from the last decade you may now be looking to bank some gains. The Financial Planner magazine, Money Magazine and others are salivating for someone who’s made some money in the past few years. Someone to call a hero.

You can almost feel the desire for returns in the air.

Next, you are introduced to a mutual fund manager who has found a trend. They’ve back tested it ten times and it looks good. In other words, had someone invested this way for the past ten years, he or she would have knocked the cover off the ball, so to speak. You hear this. You assume someone did invest that way (maybe someone did, but not likely). The person selling the product is not smiling, they are calm and reserved. They are happy to find someone else who wants to make 20%.

You, on the other hand, have had to settle for the market’s relatively flat and relatively choppy 2011. You’re not getting any younger. Your fears in 2008 were assuaged by the market in 2009 and 2010. No more fear – You’re above fear. But soon, without you even realizing it, fear’s opposite but equally destructive emotion is there instead. Say hello to Fear’s cousin—Greed.

STOP. Think. You know that the market brings return – not managers. You know that markets cannot be beat. You’ve seen it all before. The key to staying level in times like these is to remember that there is absolutely no evidence that a once-popular fund ever repeats performance. Most of the money that comes into a hot mutual fund comes in AFTER the returns are gained and just before lackluster and negative performance.

Market timers are always looking for formulas that work, that will help them beat the market. In Las Vegas, one such method is called card counting. You might remember this scene: http://www.youtube.com/watch?v=wU2FunFpzDI

Once Ray saw all the cards hit the top of the car, he knew what was left and was better able to play the odds. He had an uncanny ability to remember facts for immediate recollection.

Back testing is a trick like this. Once financial planners have a few years of evidence, they can exploit it. They can convince investors that it will work in the future too.

Don’t be exploited by gamblers and speculators. Know the truth.

~The market gives returns – not managers.

~Managers who have beat the market or, even worse, have a formula that would have beat it, never repeat. Ever.

And yes, that is a challenge to anyone who wants to try. Show me one manager who has beat the market for as long as you need them to be successful in your retirement planning, and I’ll stop beating this drum.

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