Backtesting, humility and market wisdom

13Sep06

One of the underlying themes of this blog is that investing is hard. No seriously, it really is. The investment blogosphere has been built up in an attempt to educate and inform novice and experienced investors alike in the fundamentals and nuances of investing. However, we must recognize that even armed with the best information and trading tools the game of investing is still a difficult one.

This point was driven home by the recent performance of some of the best investors on Wall Street. Henny Sender and Susanne Craig in the Wall Street Journal report on the surprisingly poor performance of Global Alpha, a $10 billion in-house hedge fund of Goldman Sachs (GS).

Global Alpha, which until recently was virtually unknown on Wall Street, is Goldman’s crown jewel in a family of alternative investments that have helped boost earnings at Goldman in recent quarters. In recent years, other Wall Street firms have branched into operating hedge funds, hoping to cash in as well. This week Credit Suisse is announcing major new initiatives in its own alternative-investment division.

While Global Alpha is a relatively small contributor to Goldman’s net revenue, the loss is notable because it occurred across many different trading strategies. It is unusual for a hedge fund trading in diverse markets to have so many misplaced bets at the same time.

Apparently Global Alpha was not alone in its underperformance for August. Ticker Sense has a neat graph showing that in August every hedge fund sector trailed the return on the S&P 500 for the month. In addition, Gregory Zuckerman in the Wall Street Journal reports on how some of the big names in hedge funds have been performing year-to-date. In a word, mediocre.

This news should in the very least raise two points. The first being that even the biggest and best investors with the most sophisticated tools go through an inevitable period of underperformance. The second point is that given this knowledge what can (or should) an individual investor do to gain the knowledge necessary to trade in the markets?

It just so happens that Eleanor Laise also in the Wall Street Journal has an article that explores two separate paths: the relevance of so-called “fantasy” investing sites, and the power of off-the-shelf back-testing tools. Let’s address both points. To start we were not surprised to read this:

As online brokerages and other financial-services firms roll out new virtual-trading tools that promise to teach the ins and outs of complex investing strategies, some individual investors are finding the transition from fantasy trades to real-life investing isn’t always a smooth one.

Our opinion of paper trading is less than positive. While paper trading can be useful for novice investors to learn the mechanics of trading we find that it is nearly useless in simulating the actual emotion-filled process of trading. A quick example should suffice.

Anyone has ever been to the race track will recognize that they approach a race very differently if they have even a $2 bet down on a horse. Despite the (likely) small payoff in the race some one with a ticket will go through a roller coaster of emotions in a two minute time span. However those without a ticket who simply had an opinion on a horse will feel little, except a little regret if their horse comes in, during the course of a race.

Any one who has paper traded and actually traded, whatever the trade size, will recognize that the difference in emotional commitment between the two is quite large. Paper trading losses are more easily shrugged off than actual losses and provide little in the way of educational merit. Trading losses are indeed the best education. Active paper trading will never simulate this process.

Again let us reiterate our opinion that paper trading can be useful when trying to learn the ins and outs of market, especially one you have not traded before. However real trading, however small the dollar amount, will always be a more powerful teaching tool.

The second theme of the Laise article tackles the subject of the increased availability of sophisticated back-testing tools for individual investors. We have written in this space before about our interest in quantitative research. However we do so with the knowledge that even quant investing has its own flaws.

Another potential pitfall: “backtesting,” or using historical market data to size up a trading strategy. CyberTrader and Fidelity, for example, both offer investors the ability to backtest trading strategies. A common problem with backtesting is that “you come up with something that worked really well in the past, but the market is always changing,” says Ken Tower, chief market strategist at CyberTrader. And since backtesting can show years’ worth of results within a few minutes, investors don’t experience the gut-wrenching ups and downs they may face when they try to apply the strategy with real cash. Mr. Tower suggests that investors look through their backtested results week by week to be sure they’re comfortable with their strategy’s risks.

Back-testing is in the end a tool, nothing more, nothing less. It can provide insight into how the markets operated in the past, but the future may be very different. Potentially the best use of back-testing software is in the risk-management tools. While the best entry/exit methods may shift over time, prudent risk management techniques never go out of style.

The markets teach even the best investors humility on a daily basis. Our hope is that investors use the many tools available to them with this in mind. Investing (and trading) is (and never were) easy. Don’t be fooled by the flashing “green means buy” and “red means sell” come-ons. Only hard work, experience and big dose of humility will lead to investing wisdom.

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