Backtesting simulates an algorithmic strategy using historical data with the goal of identifying patterns that generalize to new market conditions. In addition to the generic challenges of predicting an uncertain future in changing markets, numerous factors make mistaking positive in-sample performance for the discovery of true patterns very likely. These factors include aspects of the data, the implementation of the strategy simulation, and flaws with the statistical tests and their interpretation. The risks of false discoveries multiply with the use of more computing power, bigger datasets, and more complex algorithms that facilitate the identification of apparent patterns in the noise.
We will list the most serious and common methodological mistakes and refer to the literature on multiple testing for further detail. We will also introduce...
