In our last discussion, we pointed out some of the fundamental flaws of backtesting investment strategies. So, what’s a more viable approach toward evaluating financial strategies? We believe a more statistically rigorous and objective means is through use of simulation tests. Briefly explained, a simulation test is a way of comparing procedures for building portfolios by applying them to a variety of simulated outcomes over time.

When evaluating new investment portfolios, the use of backtesting to justify portfolio construction and trading methods is a common marketing tool among many firms. Backtesting is a traditional way of saying that a proposed investment strategy would have worked in the past, and that it would likely be successful in the future. That assumption, however, is very contentious from several perspectives.