A Bayesian Approach to Backtest Overfitting

Abstract

Quantitative investment strategies are often selected from a broad class of candidate models estimated and tested on historical data. Standard statistical technique to prevent model overfitting such as out-sample back-testing turns out to be unreliable in the situation when selection is based on results of too many models tested on the holdout sample. There is an ongoing discussion how to estimate the probability of back-test overfitting and adjust the expected performance indicators like Sharpe ratio in order to reflect properly the effect of multiple testing. We propose a consistent Bayesian approach that consistently yields the desired robust estimates based on an MCMC simulation. The approach is tested on a class of technical trading strategies where a seemingly profitable strategy can be selected in the naïve approach.

Regulatory Stress Tests and Bank Responses

“…Another stream of literature is related to the discussions on the calibration of methodologies of stress tests from macro and microprudential perspective (Andersen et al, 2019;Stádník et al, 2016;Witzany, 2017a). In the EU, EBA stress tests are run under the static balance sheet assumption.…”