Investing success involves good risk management and strong discipline. That is basically it. It sounds easy but it is not. This is summed up nicely by Howard Marks of Oak Tree Capital:
“To be a successful investor, you have to have a philosophy and process you believe in and can stick to, even under pressure. Since no approach will allow you to profit from all types of opportunities or in all environments, you have to be willing to not participate in everything that goes up, only the things that fit your approach. To be a disciplined investor, you have to be able to stand by and watch as other people make money in things you passed on.”
A back-testing engine allows you to develop a strategy which suits you. By running a back-test over many years, using stock selection criteria of your choice, you will immediately see how poorly your strategy did in 2008 to 2009. You can isolate that period and run the strategy again. This will give you some indication of downside risk.
You can test how to reduce risk. For example, you may wish to reduce the impact of industry concentration by placing a restriction of say less than 15% of your portfolio in any one industry. In addition, you can see what your strategy looks like with a high level of diversification (e.g. by investing only 1% of your portfolio in any one investment) then you can see what happens to your portfolio with a low level of diversification (e.g. by investing 7 or 8% of your portfolio in any one investment). Just by doing this, you will see large differences in risk and return generated from the same strategy.
By running a variety of scenarios, you will be able to build up a picture of how your portfolio is likely to behave in the real world. This will give you some idea of expected risk and return and will allow you to select investments with more discipline, and be more comfortable with the volatility of individual stocks in your portfolio: you’ll see them as part of the bigger picture.
It is important to remain sceptical of the results of any back-test. It if looks too good to be true it probably is. You may have created a strategy which by chance did extraordinarily well by the amazing performance of only one stock. You should export the trade results of your strategy and check the performance of all of your trades. If one or two investments explain most of your good performance, you should not rely on this as a strategy going forward, as it is unlikely you’ll find the same outperforming stocks in the future.
In addition, it is important to create simple strategies not complex ones. The more complex the strategy the higher the risk you run of fitting your strategy to historic data rather than building a strategy robust enough to handle the future. The best strategies are simple, and grounded in an economic reality that you can explain to someone in one sentence (e.g. I buy a diversified portfolio of low leveraged undervalued companies).
To learn more about the eight pre-defined ‘guru’ strategies we have already built. Click here