Pitfalls of Backtesting | Podcast Episode #278

0:05
Hey, I’m Ryan Mallory and this is my swing trading the stock market podcast. I’m here to teach you how to trade in a complex ever-changing, world of Finance, learn what it means to trade, profitably and consistently managing risk, avoiding the pitfalls of trading.

0:22
And most importantly, to let those winners run wild, you can succeed at the stock market and I’m ready to show you how, hey, everybody, this is Ryan Mallory with swing trading the stock market. In today’s episode, we are going to talk about back-testing back testing strategies.

0:39
What are some of the pitfalls and back testing and what should we be aware of. So today’s email comes from a guy we’re going to give them a Florida redneck name of Mitch Mitch rights. Hey right I have a quick question for you. I am getting started with technical analysis and was wondering when back-testing do I test stocks or run my scan and then that test the stocks in the scan?

1:01
The issue in my skin shows only a small number of stocks Please respond or answer on the podcast. Well, I’m going to answer on the podcast Mitch, but first, what am I drinking, guys? This one’s a riot, man. I found this at Total Wine.

1:17
I don’t know, I probably spent like a couple bucks on it. It was in their sample section and it’s harsh debtors. I don’t even know how to say this Hofstadter’s Slow and Low, 84 proof Rock, and Rye, and it says, in the little caption here on the can, it says Union made with Straight rye, whiskey raw, honey, navel orange, rock, candy, and Bitters.

1:40
Now, here’s the crazy. Part thing comes in like a little miniaturized. Soda can never had Whiskey and a miniaturized soda. Can I have my concerns about something like this? I don’t see it being very good. Now to its credit is actually 84 proof.

1:56
So it’s 42%, alcohol. This is something that I would expect it to be like 25%, but no, it actually comes in at 42. So it meets the threshold of okay, having Rachel just from a sheer proof standpoint, but again, I’m very skeptical. Now, it gives you 100 ml in this thing.

2:12
I filled up my Glenn clear glass and went way past like the midsection was crazy. I don’t think I’m gonna be able to drink all this stuff. I am. I’m huh, I don’t know where I’m going to be at but anyways not just eyeballing this Whiskey and You guys probably wonder sometimes why I look at the whiskey color itself because the good whiskeys are very clear.

2:30
It’s like crystal clear. A like if you were in the Caribbean and you were just able to see straight Bottom to the ocean floor. This one here is very murky. Like it does not have a lot of clearness to it and so that often happens to I think when you add honey and Bitters and all these other things to it, it just kind of like dilutes the purity of the Whisk, I am not a fan that I feel like if it’s a good whiskey, should be able to stand on itself.

2:55
So I’m not a big fan of adding anything to the Whiskey’s but that’s what the Slow and Low Rock and ride. Does they add to it now the eyeball test Doesn’t pass on the nose, definitely some really strong Citrus flavors. It smells a little sweet too, but I don’t really know what to make of that, but it’s a strong Citrus flavor to The Taste, man.

3:17
It’s strong, honey, flavor, strong, orange, and citrus flavors. I can definitely taste some of the bidders that they added to it. Is it enjoyable of a drink? No, as it satisfying know, if somebody handed to me at a party or a cocktail get together, would I necessarily be upset by it?

3:35
I kind of expect a lot of places that I go, whether it’s restaurants or just any place for that matter when they hand me a cocktail or when they hand me a whiskey, I don’t have like high expectations for it and this would be like along the lines of something. I don’t have high expectations for nor is it meeting expectations.

3:51
It’s almost like they’re trying to come across the some kind of like old-fashioned but they give it to you in a candle as if you’re supposed to just drink it right out of the can it’s warm. It doesn’t have like a cocktail feel to it right out of the can, maybe you do. You need to put it on ice but on the candid just says don’t need no fixing drink, straight up or with ice drinking straight up isn’t satisfies.

4:14
I don’t know why they put that on. The can I would actually put on the can serve it with some frickin ice. Now for this I actually woke my wife up it’s like you gotta try this. Tell me what you think. Is it straight out of a can and she told me oh, this is awful. It’s like a 1.8 Max 2.1.

4:30
I’m gonna be a little bit more generous and say it’s a 3.7 the aftertaste on. It’s a little bit. It’s almost like your tongue falls asleep. It has that like, little sensation of like, when your arm falls asleep or something like tongue, fallen asleep, has a little bit of heat or it tries to come on with some heat, but it doesn’t do enough to satisfy 3.7 man, and maybe that’s generous, but that’s about as high as I can go with that one.

4:51
So low and low 84 proof Rock and Rye 3.7 again, not a fan. So, back to Mitch and back-testing, I don’t do a lot of podcasts on back-testing. I think one of the reasons why is that, I don’t do a lot of Back testing myself, I’ve done it in the past.

5:07
I know quite a bit about it and I have a lot of concerns about running these formulas or systems when it comes to back-testing especially with what’s on the commercial market and the tools that they give you for it. I don’t have a high level of confidence in it. So, Mitch talks about here, hey, I’m getting started with technical analysis was wondering about when I’m doing back testing and he talks a little bit more about it.

5:30
Well, I would stop him right there and just say, hey, if you’re just starting to learn about technical analysis, More just of the technical analysis. Don’t get caught up in the back testing yet. Try to develop a foundation of understanding when it comes to technical analysis because there’s a lot of it. I mean, you can read for months and months and months.

5:47
If not years on technical analysis, there’s all sorts of different strategies, there’s all sorts of different approaches and so if you’re just starting off a technical analysis, if you do do a back testing strategy, it’s going to be probably rather basic and probably not something that takes into account.

6:03
A lot of the factors that you need to be and into account when it comes to back testing and we’re going to get to those here in just a second. But if you’re starting off with technical analysis, focus on technical analysis. Don’t be so quick to jump into back-testing. It’s just like people who are just starting off with trading and their trading stocks and all of a sudden, two days later.

6:23
They’re jumping into freaking options or crypto or into leverage DTS or going full-tilt margin on their account. It’s much better to stay away from Things and just learn how to trade stocks. One of the things that I like, least about back-testing is that they do a horrible job of accounting for risk.

6:43
Yes, you can put on the back test. Hey, if a stock goes down 4%, I want to go ahead and get out of it. Okay, that’s what most of your back testing, strategies involves. If it goes down, XML, sell the stock. The problem with that is that it doesn’t take into account a strategic stop-loss.

7:00
Like most, if not all of your back testing strategies, I’ve not come across one that actually takes into account. This is that, it doesn’t really look into where the stop loss should be placed at. You could say 4 percent on every trade and backtest off of that. But then, are you really taking into account of stock that maybe should have a 5% stop loss or 2%, stop loss that can make huge differences in your trade.

7:21
It can be the difference of being stopped out or not being stopped out. Like, if the stop loss should be 2%, but you played it at an arbitrary 4%, well, you get stopped out at 4%. Well, you’ve probably should have been stopped out at 2% and you could have cut your This is in half or maybe it should have been at 5% and it goes down four and a half percent, your stopped out but then it hits four and a half percent and goes right back out because it started testing a key support level that your stop loss was placed right underneath and it starts to Rally again.

7:47
You made 15 percent. That’s all of a sudden, a huge thing. That’s a 20% difference on that particular trade. So I think back testing does a very poor job of risk management. And when it comes to back-testing to, if you’re still going to say, hey I’m going to use just like a basic stop-loss, number four percent on of trade or 5% on trade, whatever it is then you got it.

8:05
Look at the average. Drawdown of your trading strategy. Okay, let’s say, the stock trading strategy is up a thousand percent over the course of a ten-year period, but the average drawdown was 80%, okay? You’re going to go ahead with that strategy but can you really stomach an 80% drawdown?

8:24
Let’s say you’re trading with a hundred thousand dollars, what if you get that drawdown right in the very beginning can you really stomach a drawdown that goes from hundred thousand down to 20,000 and then bounces back up. Maybe you Hand, but going down to 20,000 dollars along the way. That’s going to create a lot of restless nights, a lot of emotions, a lot of problems and good chance that you give up on the trading strategy before it ever gets there.

8:45
And then all of a sudden you don’t have that money anymore. And what’s even worse, is, let’s say instead of waiting for it to get all the way down to 20,000, you bailed out when it was only thirty thousand dollars left in the count, you suffered a 70% draw Downs, as I can’t take it anymore and then you see it go, you know, even further you feel a little bit of Justified for going ahead and getting out of your accounts, like, aha.

9:03
See there. I told you I was going to keep going down. I made the right decision I saved an extra ten thousand dollars or whatever and then you see a bottom and it goes right back up and now all of a sudden the hundred thousand dollar account that you were initially starting with would have been worth two or three hundred thousand dollars. Now what’s happening?

9:21
Yes, you got out with a portfolio value of thirty thousand dollars and now you’re not even in the market but you’re wrestling with the anguish of knowing that had you just been a little bit more patient how you just wait until it rolls all the way down to twenty thousand dollars and value that you could have been.

9:35
Only profitable, but the fact of the matter is, as humans were very emotional. We don’t want to see our accounts go from 100,000 down to twenty thousand dollars and so, oftentimes were bailing out at the worst possible time. So risk management is very, very important when it comes to swing trading strategies.

9:52
You got to make sure that whatever system that you use that, whatever the max drawdown is or even the average drawdown, that, that is something that you can stomach and guess what? Just because they like the max drawdown might be 80%, does it mean that there isn’t A future, 90%, drawdown or a 95% drawdown.

10:08
And that’s even worse because it’s not giving you the Max Payne. It’s just telling you what it’s done in the past, doesn’t mean that it can’t be different in the future. It’s like, you take an individual stock, right? You hear all the time. This stock has never had this bad of a month or hey, this is the most the stock has ever dropped in a given year.

10:26
Well, that kind of flies in the face of like previous back tests, wouldn’t it? So, just because that the max drawdown is let’s say 30%. It doesn’t mean, it can’t have a drawdown of 70%. So back tests are really just a look at the past. And he talks about here, he doesn’t have enough of a sample size.

10:44
Well, it really depends on what stocks you’re trading. Like if you were just going to be trading, Fang, stocks. It’s a meta Apple. Amazon, Netflix, Google Microsoft and Tesla. Then you would backtest just on those. If you’re going to trade the entire Market, you need to back test on the entire Market, taking a sample size. It’s a handful really doesn’t help at all because that handful could just be a favorable sampling.

11:04
If you’re going to trade the the entire Market, my opinion, you should backtest the entire Market. The other thing, too, you got to account for position sizes. So what do you do if you get 20 signals to buy but you’re doing 10% position sizes, then if you’re only doing ten percent position sizes, and there’s 20 trade signals, you’re either going Full Tilt into margin or you’re giving up on 10 of those trade signals that you should be taking the problem with that is then all of a sudden.

11:32
What if the best trait of the year is being left out, Of those ten that you didn’t take. And that’s what really makes the difference for the trading system versus beating the market versus not beating, but then let’s say, hey, okay, we’ll use 5% position sizes. Well, let’s say that over the course of 10 years.

11:47
You only have like one or two moments where you were fully invested in the market and the other times you were only like 30 or 40 percent best in the market. But there were plenty of times that you should have been bested fully but you weren’t vested fully. So you see what I’m trying to say is like the position size is going.

12:05
Be very, very difficult to be able to find that happy medium between. How many stocks are you going to trade it? What if you’re trading A system that has 100 signals? Are you really going to trade? Just 1% position sizes? Maybe if you’re a hedge fund, but if you’re not a hedge fund, then it’s going to be very difficult. And if you are trading a hundred position sizes, are you really being the market at that point?

12:22
Because the more stocks that you trade, the more likely you’re going to just basically give you the returns of SP, why? And here’s the other thing, that’s very interesting. If you are doing your back testing based For the last 13 years of trading, you’re really not giving yourself a fair outlook on how well that trading strategy is because the last 13 years we’ve been in a Raging Bull Market helped large and part by the Federal Reserve.

12:48
So what do you do when the Federal Reserve is not helping out? How does the trading system perform? Let’s say in the 90s, let’s say in the 70s is it actually going to back test off of the companies that were in the 70s because a lot of your companies that are trading today weren’t involved in this 70 so it almost needs to focus on the competition.

13:05
These are actually around in the 70s and that information is very hard to come by. There’s not a lot of systems that are out there that are giving you back tests that include 2008 and stocks, like, Enron and Lehman Brothers. It’s just really the stocks that are trading today, so if you go all the way back to the 70s, yeah, you’ll probably be back testing forward.

13:24
You’ll be back, testing GM. But your sample size is probably going to be a lot smaller because they’re not keeping historical data on some of these companies that are non-existent or got acquired in. Are no. Were publicly traded like take for instance, LinkedIn. That one got acquired by Microsoft. What if you did a back testing strategy, going back to 2010 and it doesn’t include LinkedIn.

13:45
What’s the problem there? Well, what if LinkedIn was responsible for 50 or 60 trading, signals, between the time that you started, the back testing in the time that it got a choir and you’re not including that in your back testing. Well that’s kind of a problem right? And so when you start back testing in Bear markets to most of your back testing strategies will blow up in a bear Market.

14:05
And it’s kind of like doubling down what worked in a bull market, does not work in a bear market and so you’re trying to apply the same tragedy and back. Testing results are just chaos and losing all your Capital. So if you’re going all the way back to 2009, yeah, there’s a few pullbacks there, you had European financial crisis, you have the pullback in 2018, you have the covid crisis, but you don’t have a ton of them.

14:28
There’s another problem to curve fitting. Man, we look at like, okay, if I just tweet this and I tweak that and I tweak this and I tweak this Here you start to curve fit but when you curve fit a strategy to the exact past doesn’t mean that’s going to replicate into the future. So you got to be cautious of that.

14:44
But I tell you what, one thing that’s not a bad idea is subscribing to swingtradingthestockmarket.com. We’re going to get all my stock market research each and every day. Now, it’s a little different than the trading block that I offer on SharePoint, ER, where you get all my stock picks real time through alerts and everything else.

15:00
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15:17
So to summarize what we’ve talked about with this podcast, guys, if you’re just starting off in technical analysis, focus on the technical analysis. I would save the back testing for another day. Also, in your back testing, if you’re going to do it, make sure that you’re taking into account risk management and Addition sizing.

15:36
And where are you placing the stop losses is just going to be 4 percent on every trade. Or you actually going to have a way to place the stop loss below strategic levels and can you handle the draw Downs that are in the back testing strategy and make sure as well not to curve fit and don’t Focus your back testing strategy on the last 13 years of a Raging Bull Market, make sure you got the 2000 involved in 2008 involved and maybe some of that stuff from the 80s and 90s.

16:03
And if you enjoyed this podcast, make Sure, that you leave me a five star review, on whatever platform you’re listening to. I appreciate that. Keep sending in your questions, guys, not enough, you guys are sending and questions. I need more of them. I want to look at them. I want to put them on the air. I’m not really a guy that gets into the tax questions.

16:19
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16:37
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16:57
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