6 Reasons Why You Should Backtest Your Portfolio
As an investor, you need to have the right knowledge and tools available to you in order to monitor and maintain your portfolio performance. There are a number of challenges that investors face and many external factors influence the success or failure of a certain investment.
One of the most powerful tools for investors to use is backtesting. Backtesting your portfolio as an investor is a smart habit that helps you gather intel and data on the investments themselves. This allows you to make better-informed decisions that will hopefully enable your investments to flourish into something more substantial.
In a CFA Institute survey of almost 250 analysts, private wealth managers and portfolio managers, 50% of respondents reported conducting backtesting as an investment strategy within the past twelve months of the survey date.
If you decide to do backtesting on your portfolio, then it’s certainly something worth doing for the health and performance of any portfolios you manage. Whether it’s a personal portfolio or one of many you manage for clients, backtesting proves significantly effective.
This guide will share all you need to know about backtesting your portfolio and how it’s beneficial. We’ll also share some top tips on strengthening your portfolio(s).
Table of contents
- What is backtesting
- 6 reasons to backtest your portfolio
- 1. Useful when using automated trading platforms
- 2. It helps investors understand the behavior of investments
- 3. Determines how much risk there is within the strategy itself
- 4. Helps diversify portfolios into low and high-risk assets
- 5. Provides portfolio managers and traders with more confidence
- 6. Data is always going to be useful to have available
- Fives tips for strengthening your portfolio in 2023
What is backtesting
Backtesting is a valuable and effective practice to assess the viability of a trading strategy through historical data. This tool that’s used in investment portfolios operates on the theory that any strategy which has worked well in the past, is likely to be effective in the future.
The same theory is played out and vice versa too. If the strategy was a poor one, producing mediocre results, then it’s likely to do the same again.
Traders and analysts, including those who manage portfolios, use this testing to analyze risk and profitability. They are able to make decisions based on this data before they invest any capital. Of course, it’s not always guaranteed to work, especially when working on the theory mentioned above.
However, for many portfolio managers and owners to be using backtesting, it seems appropriate to try it out for yourself, right?
As long as the backtesting is conducted successfully, it’ll provide positive results that give traders assurance about the strategy in question. Alternatively, if the strategy yields negative results, then the trader is able to decide whether to adjust or bin the strategy for something else.
If the trading idea is quantifiable then it’s possible to be backtested. Some traders may wish to work with programmers in order to make certain ideas testable when they’re not currently.
6 reasons to backtest your portfolio
Why backtest your portfolio? Investments are risks that are often volatile and unpredictable. While that might be true, many investments rely on strategies to provide positive results. Backtesting these strategies is a way of screening the strategy in advance and highlighting any potential pitfalls or issues within them.
While it’s not 100% foolproof in its effectiveness, it is something that’s worth the extra effort to do. Here are 6 reasons to backtest your portfolio this year.
- Useful when using automated trading platforms.
Within this digital age, it’s helped many traders and newcomers to invest, to begin investing, even on limited funds. The introduction of new investment types such as cryptocurrency, NFTs and peer-to-peer lending means investors need to sift out the good from the bad.
Automation has also become widely popular amongst traders now, with an automated trading platform being an attractive prospect for those who handle multiple portfolios at once. With backtesting, it provides the results that will help the trader, tweak and adjust their current investments appropriately.
While automated trading platforms are useful for streamlining and saving time, they still need monitoring. The use of historical data to understand where investment may be heading or how much risk is attached to it, helps traders set the relevant parameters within these automated platforms.
That way, they’re helping mitigate the risk of their capital as best as possible.
- It helps investors understand the behavior of investments.
Backtesting is useful for investors because it helps understand the behavior of an investment in relation to key events in financial history. For example, the pandemic caused a lot of panic among investors due to the uncertainty it caused.
According to one source, the outbreak of COVID-19 caused 28% of investors from around the world, to move a significant proportion of their portfolios to lower-risk investments.
These financial crisis events, whether they’re localized or global, do impact the behavior of an investor. Using this historical data helps investors understand their strategy’s behavior during these negative financial events. As a result, they’ll know how much they’re expected to lose roughly.
- Determines how much risk there is within the strategy itself.
As an investor, the amount of risk that’s attached to a certain strategy and asset will determine whether they choose to go ahead with it or not. For some portfolio managers, they may have clients who have been specific about how many high-risk or low-risk assets they want to invest in.
The use of backtesting helps to determine how much risk there is within the strategy itself. That’s helpful for the trader to have more intel on whether it’s a viable opportunity or not. Of course, every investor is different in their approach and needs for the portfolio.
For older investors, high-risk assets might not be appropriate at this time when those individuals may be close to cashing in. Younger investors may wish to take on more risky strategies because they have time to bounce back should it fail.
- Helps diversify portfolios into low and high-risk assets
In one particular statistical analysis, the researcher found that diversified investments produce higher returns and face lower risks.
Utilizing historical data through backtesting helps the portfolio manager or trader to understand what assets pose the most risk and which ones pose a lot less. Diversifying a portfolio is a great way to help spread all your eggs across multiple baskets. It’s a common attitude that putting all your eggs in one basket, is risky – and that’s true.
Even those assets with a slight degree of risk could result in a loss of capital. Whether it’s a personal portfolio or one being managed, losing capital is something you want to avoid. Backtesting is a method that is preventative in its efforts for investors making those investments.
- Provides portfolio managers and traders with more confidence.
Confidence in your portfolio and how you manage your portfolio is essential. Sometimes you need to be willing to take that risk in order to reap the benefits. However, backtesting provides the backbone that investors need to take that leap of faith. At least with the use of historical data, they’ll be going into the investment with a bit more awareness of what to expect.
With more data and insight into a strategy’s potential risk, traders and portfolio managers are able to move forward with more confidence than they would have had prior to backtesting.
- Data is always going to be useful to have available
If you’ve been sleeping on data, then chances are, you’re not getting the full picture when investing. As an investor, data is helpful to understand what has happened in the past, what’s occurring now, and what could potentially transpire in the future.
Backtesting is a useful practice to implement, especially as it relies on historical data to help predict how a strategy could perform in the future. While it doesn’t always work, it’s better to have some form of data to make decisions upon, rather than basing your investment decisions on assumption.
Five tips for strengthening your portfolio in 2023
If you’re looking to strengthen your portfolio, then there are some general tips that will help give it the best chance of success. Of course, none of these methods are guaranteed to provide results but they may help turn some of those losses into the occasional wins.
- Don’t get arrogant
- Diversify your portfolio
- Vary the risk with assets you invest in
- Improve your knowledge of investment
- See failure as an opportunity for success
Arrogance is going to risk you slipping up on your investments. Make sure to stay humble and always look out for opportunities to diversify your client’s portfolio – or yours if it’s a personal one.
Be sure to mix your investments up with a variety of high and low-risk assets and switch your attitude on failed investments. Every failure is an opportunity for success. Improving your knowledge of investments is only going to benefit your efforts further in the future.
Try backtesting for your portfolio
Despite it not being fully truthful in the results it provides, backtesting is worth trying for portfolios, whether they’re a year old or several years old. If there’s one improvement you make upon your asset choices in this era, it’s to conduct backtesting to make more insightful decisions on which assets you decide to invest in.