Without a testable theory that explains your edge, the odds are that you do not have an edge at all. A historical simulation of an investment strategy’s performance (backtest) is not a theory; it is a (likely unrealistic) simulation of a past that never happened (you did not deploy that strategy years ago; that is why you are backtesting it!). Only a theory can pin down the clear cause–effect mechanism that allows you to extract profits against the collective wisdom of the crowds – a testable theory that explains
Without a testable theory that explains your edge, the odds are that you do not have an edge at all. A historical simulation of an investment strategy’s performance (backtest) is not a theory; it is a (likely unrealistic) simulation of a past that never happened (you did not deploy that strategy years ago; that is why you are backtesting it!). Only a theory can pin down the clear cause–effect mechanism that allows you to extract profits against the collective wisdom of the crowds – a testable theory that explains factual evidence as well as counterfactual cases (x implies y, and the absence of y implies the absence of x). Asset managers should focus their efforts on research-ing theories, not backtesting trading rules. ML is a powerful tool for building financial theories, and the main goal of this Element is to introduce you to essential techniques that you will need in your endeavor.
Contrary to popular belief, backtesting is not a research tool. Backtests can never prove that a strategy is a true positive, and they may only provide evidence that a strategy is a false positive. Never develop a strategy solely through backtests.
Contrary to popular belief, backtesting is not a research tool. Backtests can never prove that a strategy is a true positive, and they may only provide evidence that a strategy is a false positive. Never develop a strategy solely through backtests. Strategies must be supported by theory, not historical simulations. Your theories must be general enough to explain particular cases, even if those cases are black swans.
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