What if you could see how your trades would work out before you placed them? Sounds like a surefire ticket to investment success.
In a way, that's the opportunity that backtestingGlossary: Testing an investing rule on historical data to see how it would have performed before putting money behind it. offers investors. Backtesting involves using statistical methods to measure the correlationGlossary: How closely two investments move together, from +1 (always in step) to −1 (always opposite). Holdings with low correlation to each other give a portfolio real diversification. between financial data and subsequent price movements.
The appeal of finding a statistics-based formula to anticipate market movements is obvious. If the idea sounds a little too good to be true, your skepticism is healthy.
Backtesting can be a valuable tool, but only if it's applied with a clear recognition of its limitations.
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