I have been back-testing some share investment strategies for my SMSF (self managed retirement fund) and have narrowed it down to two strategies that have consistently performed the best over a 3 year period. A summary of the two strategies is summarised in the table below:

Investment Strategies

The starting capital for both strategies is $50,000 and the chosen strategy would only form a portion of the total investments in the fund which would also include some direct property investments, some cash and possibly some bonds.

Strategy A had a Compounded Annual Return (CAR) of 25.5% and almost doubled the initial investment in 3 years compared to a whopping CAR of 41.1% for Strategy B which almost tripled the initial investment over the same period. Looking simply at this information it seems like a no brainer to choose Strategy B. However, being a retirement fund, would it still be wise to choose Strategy B over Strategy A?

Notes Regarding the Strategies: In the back-testing for both strategies all trades where bought at the open on the next day once a signal was given and a 20% trailing stop loss was automatically placed on each open trade. I also plan to test both of these strategies going forward over the next 12 months in a virtual account to verify the results and avoid curve fitting the back-tested results. Once this is done and the results are confirmed I could start trading a real account in either 2016 or 2017 (depending on when I set up my SMSF), so if the results do not correspond to the back-testing I still have a further year available for additional planning.

  • What you really want to know to evaluate their suitability are the risks; the likelihood of a significant decline in value, which might leave you much less money for retirement. You can't directly tell that from past returns, but in general you might expect that an investment that is volatile enough to show huge returns over a fairly short period is also volatile enough to show huge losses. – Nate Eldredge Dec 30 '14 at 4:42
  • @NateEldredge - that is why I have included in the table the maximum drawdown over the 3 years and other relevant information. – Victor Dec 30 '14 at 4:44
  • I was going to ask about that too. You've included the max drawdown and winners/losers ratio, so isn't that your answer? The reason you might choose A over B is that A has a higher win/loss ratio and lower chance of heavy losses. – BrenBarn Dec 30 '14 at 5:14
  • @BrenBarn - I'd be happy with a win ratio of above 50%, so I don't see that as a problem. – Victor Dec 30 '14 at 5:44
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    Having a trailing stop loss of 20% most of the positions are open for the medium to long term - from say 6 months to 3+ years - in other words at the end of the 3 years a few positions were still open and had current profits of over 100%. – Victor Jan 3 '15 at 2:13

If you can travel back in time, and start investing at the start of the period of the back-testing, the strategy with the higher return is better.

Past performance is not a good indicator for future performance, since markets change. But it's often the best we have.

A single 3 year period is not exactly good back-testing for a solid investment strategy. You can improve the back-testing by testing different scenarios instead of just a single 3 year period, and you will notice that in some of them Strategy A will come out on top. Make sure that you use different scenarios for fitting and for testing, otherwise you simply optimize for the testing scenarios. You will also notice that some times both strategies will lose a lot of money. Which strategy you chose then depends on which scenarios you expect to be how likely to come up in the near future, and how much money the strategies gain/lose in each of these scenarios.

  • Choosing the strategy with the highest return may not always be the best option, especially when that strategy might be too volatile that it keeps you up at night. Regarding using only 3 years of backtesting - I have already mentioned I will also be doing up to 2 years of forward testing, and that the testing period is a good representation of the strategy because during large market downturns such as the one in 2008, my system does not trade and the stop losses on any open positions would be tightened to protect profits and capital. – Victor Jan 3 '15 at 23:04

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