The Value of a Back-Test and Momentum Investing

I recently saw the reality sitcom “Shark Tanks” {Season 10 is available on Amazon Prime}. As an entrepreneur, this is an amazing show highlighting the tough path of bringing an idea to reality. While I kind of dislike the behavior of the Sharks who act pretty cruel, this being television and if they are really investing real money, they have all the right to ask the tough questions.

The two main deal breakers for those who couldn’t get a deal were 

1. The person has a great idea but is yet to execute or has failed at execution. 
2. He or She is not fully committed to his enterprise (it being either a part time venture or one of the multiple he is trying to run)

The gap between an idea and the ability to execute it so wide that the vast majority of those with ideas are never really able to execute successfully. You may have heard that google wasn’t the first search engine, but did you know that even the famous logic of Google thata set it apart – ranking of page – wasn’t new. It was invented by Robin Li Yanhong who later went onto found Baidu.

In the Shark Tank, of the few ideas that seemed to be vetted among the thousands that come up for a chance to pitch. But even among the few we are able to see, it’s interesting to see how vast the difference is between those who are just ideating or have had a one off viral sales and one who has worked round the clock to ensure consumer connect and is trying to fulfill a requirement.

The second and what has been generally a deal breaker is the commitment of the entrepreneur to his baby. Most if not all are fully committed and often have invested big money of their own savings before coming to pitch to sell an equity stake. The Sharks seem to hate those who are still currently employed elsewhere while trying this out in their free time (there have been exceptions, but since we don’t have data on all those who apply and get rejected, I would assume a vast majority would fall in this category).

When it comes to finance, it’s easy to talk about how great one’s stock picks are or how great one’s strategy is. The spin can be narrative on the company, it’s great products, it’s wonderful management, it’s enormous scope among plenty others or the quantitative spin.

The quantitative spin refers to the ability to showcase back-tests that show how you could have multiplied your money using a particular strategy that has been discovered by the strategy seller. But most such back-test fail when they are implemented in real time with real money.

The reason for the failure lies in the fact that rather than start with a hypothesis that has a strong fundamental backing, most back-tests are based out of testing hundreds or even thousands of rules till one stumbles across the one that seems to meet every characteristic one was looking out for.

For example, take David Leinweber‘s totally brilliant discovery: that butter production in Bangladesh, U.S. cheese production, and sheep population in Bangladesh and the U.S. together “explained” (in a statistical sense) 99% of the annual movements of the S&P 500 between 1983 and 1993. (Link)

Unfortunately post the discovery, the whole correlation fell apart. But that is what data mined back-test is all about.

Back-testing today has been made very easy thanks to the availability of data and processing power that can run through millions of combinations to find the optimal ones with relative ease. A small investor or a trader sitting on a laptop can find good correlations combining multiple strategies using tools such as Amibroker or R.

A good back-test is built on a hypothesis that is of a sound nature. The reason for testing the data of a historical era is to try and understand if certain strategy that sounds interesting and worthwhile to follow has in the past delivered returns of the nature we seek.

While years of history can be tested and plotted in a few minutes, the reality is much different even if history repeated itself as much of back-test assumes.

Assume for instance a strategy that delivered great returns. This despite the fact that it did not reach its all time high for 6 years after a very great run. 6 years of being under-water is something no investor relishes and one that is a huge career risk to a fund manager. 

Would you be willing to bet on such a strategy. Remember, this strategy beats the hell out of any other comparable index in the long run, but how long is something that is left undefined. If you are willing to invest, how much of your equity holding would you be willing to allocate?

On smallcase, I am finding more and more advisors launch momentum strategy. This is good for more advisors mean better appreciation and understanding of a strategy. But it comes with a caveat – most of the back-tests are extraordinarily good. That in itself is not a bad thing if the strategy is properly tested but with not much data available publicly to validate the same, it sounds a bit too good to be true.

A second disappointment is the fact that many advisors offer packages that come as low a time frame as a month. This when testing would have shown them that even after 3 years, there is always a probability of the client being in the red. 

Back-tests should always be taken with a bag of salt unless you have been able to replicate it yourself. But that is generally not possible due to the proprietary nature of the strategy even though if you were to look at the portfolio’s, more than 80% of them would overlap with each other. As the famous quote from Kungu Panda goes, “There is no secret ingredient”

But beware of strategies that try to do too much – looks great in testing, can be sloppy when it comes to real time. The ideal way to improve your returns always lies with you – allocating right. Tinkering to show better returns is easy, but it always comes with a cost to the end user. More variables, more prone are the results to data mining bias.

Momentum Investing is no different from other factor investing strategies when it comes to recovery periods from draw-downs. They suffer like everyone else, the only advantage being that when they perform, they outclass most others. 

Do not venture unless you are committed for the long run for the short run is mostly messy and one that is unlikely to provide favorable results other than in unusual periods such as 2017.