What Is Backtesting?
Backtesting is the process used to make sure a trading strategy, or a trading signal, is actually profitable. While there is no guarantee that history repeats, I have found that over a long enough time period it usually does. The January Effect is a trading strategy that doesn’t work every year, but over several years it does.
What an investor or trader should do when they think they have found the signal a stock will rise or fall is to backtest it by going back ten years or more. The longer the better. You want to test the signal over every type of market (up, down, or sideways market). You can go to websites like Yahoo Finance for historical data and charts.
In my early days I would use the financial newspaper, Investor’s Business Daily for historical data. I saved every edition and painstakingly went day by day, pretending I was trading my signals. I would record all the results down on paper. If not profitable, I would start over. Extremely time consuming.
Nowadays, one can use computers and spreadsheets to handle most of the data gathering and processing thereby speeding up the process. What would take days and weeks now only takes hours or days. It’s definitely time well spent.
Backtesting Gives Confidence
In addition to proving your signals are profitable, backtesting your signals and proving they are profitable, will give you the confidence you need to stick with a strategy. All signals go through bad times. Knowing your signals work will give you the confidence to stick with your signals even in bad times.
I can’t stress how important confidence is. Most investors lose their money because of fear and greed. When scared, they sell too soon or, even worse, too scared to trade. Greed causes investors to hold too long, or to buy at the wrong times.
Following and sticking to proven signals (proven because you backtested) keeps investors from falling victim to fear and greed.