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I am a master student in finance and I am working on my portfolio management thesis. Within my thesis I will have to backtest a portfolio strategy for a balanced portfolio.

I am looking for a guide/ paper that describes how to backtest an investment strategy. Preferably the guide/ paper is oriented towards research. I have never done any backtesting before and I am not yet aware about the pitfalls that could occur during the process. I would like to work with Matlab or Excel (Python would also be possible, but less preferred).

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    $\begingroup$ Arnott, Harvey and Markowitz seems like a good starting point. $\endgroup$
    – shabbychef
    Oct 15 at 20:15
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    $\begingroup$ The two main pitfalls are 1. Information leakage, e.g. your backtest through some way or another learning information from the future and using it for current decisions. This can happen in subtle (for example, revised macro data, or not using delisted companies in the universe) or not so subtle (using the future price to trade) ways. The second possible pitfall is unrealistic assumptions on execution on transaction costs of the strategy - for example, if one assumes they can execute large orders are market open with no slippage, or trade large lots of small, illiquid stocks with no slippage. $\endgroup$ Oct 15 at 21:06
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    $\begingroup$ The second requires the modelling of comissions + market impact, which can be as simple or as complicated as you'd like to make it. $\endgroup$ Oct 15 at 21:07
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    $\begingroup$ Perhaps this is useful: papers.ssrn.com/sol3/papers.cfm?abstract_id=3374195 (though it uses R). $\endgroup$ Oct 18 at 9:17
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This was too long for a comment, so I'm writing it as an answer. I have provided some interesting literature that will give you insight into the common pitfalls of backtesting algorithmic trading strategies.

Marcos Lopéz de Prado on backtesting:

Marcos Lopéz de Prado provides some very good slides giving you a quick introduction to the goal of backtesting, before diving in to the common pitfalls of backtesting algorithmic investment strategies based on predictive models (this relates to portfolio backtesting as well). He argues that the hardest pitfall to avoid is the multiple testing problem (ie. adjusting your model/strategy based on multiple backtests is dangerous), and presents some solutions to avoid this problem. In general, his presentation is related to his own co-authored papers specified below:

Alternative literature:

There's also Daniel P. Palomar's slides on backtesting that tells you seven sins of implementing quantitative investment strategies (survivorship bias, transaction costs, cost of shorting, multiple testing problem etc). He further gives an introduction to ways of doing a backtest, which includes cross-validation, walk-forward and k-fold cross-validation. In the slides, he also refers to some of the papers of de Prado, described above. The slides are from the course Portfolio optimization in R found here.

Alternatively, if you want a research-based paper you can take some inspiration from Victor deMiguel's paper Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy?, detailing how mean-variance portfolio models fail to outperform the heuristic equal-weight portfolio out-of-sample. The study provides a way of comparing different portfolios and does not relate much to backtesting.


All in all, it will be a good idea to ask your supervisor for additional reading materials regardless of the above. He will point you in the right direction and might suggest well-known backtesting literature or methods he is familiar with.

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