What is Portfolio Backtesting and How Can You Benefit from It?

Let’s say you want to buy an expensive gadget. Do you simply buy it or analyse its features and compare it with similar models? In all likelihood, you will view its features diligently and compare them. Portfolio backtesting works on the same concept. Through backtesting, you can analyse a portfolio’s performance for informed decision-making.

What is portfolio backtesting?

Portfolio backtesting is a method of analysing a portfolio's performance based on historical data. It can help you understand how a portfolio would have behaved under certain conditions, and backtesting strategies help you evaluate effectiveness before real application.

Imagine you want to invest in technology stocks and want to see their performance during economic downturns. Backtesting will help you understand how this strategy would have fared during past recessions like the global financial crisis in 2008. The insight would help you formulate your real strategy going forward.

Prerequisites for backtesting trading strategies

Here are the prerequisites to backtest a portfolio:

• Correct datasets

Data is the backbone of backtesting. Correct data sets lead to accurate information about performance and help you make better decisions. On the other hand, incorrect data could lead to false results.

• Fundamental and technical analysis

While fundamental analysis can help you gauge market sentiments, technical analysis can help you gauge the performance of stocks.

• Basic understanding of statistics

Understanding key statistics terms like standard deviation, mean and variance can help you better understand backtesting.

Benefits you get from backtesting trading strategies

Backtesting trading strategies offer multiple benefits. Some of them are:

• Helps in risk management

Backtesting helps you see how your investment strategy would have performed in different market conditions. This can help you manage risks effectively.

• Informed decision-making

A holistic understanding of potential returns and risks can make more intelligent decisions about capital allocation.

• Strategy optimisation

Backtesting gives you insights into a trading strategy's strengths and weaknesses. This can help you refine and optimise before committing.

• Helps avoid emotional bias

Trading under emotions often doesn't yield the desired result. Backtesting helps you formulate a strategy through historical evidence of its effectiveness. This helps reduce temptations to make emotional and impulsive decisions.

• Helps build confidence

Once you view how a strategy has performed in the past, the same could help build confidence. This can help you navigate market complexities with gusto.

Wrapping it up

While portfolio backtesting is a powerful tool, past performance doesn't indicate future results. Its accuracy depends largely on the quality and correctness of historical data. That said, it can help you make data-driven decisions, identify risks, and optimise your investment approach.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.