Ask Matt: How valuable is back-testing for investors?
— -- Q: Does back-testing have any value for investors, or is it just revisionist history?
A: Brokers are trying to convince investors it's worthwhile to look in the rear-view mirror.
A number of leading brokerage firms, including TD Ameritrade and Fidelity, are offering tools to customers so they can see how a stock-picking strategy would have worked in the past. Such "back-testing" is commonly used by investment professionals who have investment theories they want to evaluate.
TD Ameritrade's thinkorswim unit, designed for more active traders, offers a thinkOnDemand tool. The technology lets you design a trading strategy, and then go back in time, to see how that strategy would have done any day after Dec. 7, 2009, which is the day the TD Ameritrade database starts. Investors can also use virtual money to construct a simulated portfolio to see how it would have done.
For academics, market researchers and curious investors, back-testing can be an interesting tool. It lets anyone who has a hunch about a way to make money from the stock market to see how it would have worked in the past. It's pretty common for sophisticated investors to do research, find an anomaly in the stock market that can be profited from, and then try to build systems to take advantage. Back-testing is a way to see if the strategy would have worked.
But back-testing is also a dangerous tool in the wrong hands. Remember that hindsight is 20-20. You might find a pattern in trading that worked beautifully in 2009, but isn't going to continue to work now. The strategy that scored big gains could be discovered by other investors and traded away. Other times, a strategy might have been brilliant in one economic climate, but works terribly if conditions shift.
If your broker provides back-testing tools, by all means check them out. If you have a hunch of a strategy that would work, back-testing might show you right away that it didn't work before. But back-testing is, as the name implies, very backward-looking while investors and the markets are extremely forward-looking. Back-testing is a tool, but not one to use as the sole basis for your investment decisions.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies and Fundamental Analysis for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Follow Matt on Twitter at: twitter.com/mattkrantz
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