Don't invest in another strategy until you read this - How to backtest and prepare for red day.

The market has been red. Very red. Lots of blood. Lots of pain and despair. I think the pain can be mitigated with information.

Lets discuss.

So, hopefully you all know how I feel about backtesting in most situations.

Heres a meme if you don’t.

I’ve argued for months that Composer would be better off hiding the backtester behind a knowledge test on how to read and use it, and that they could avoid a lot of churn in their userbase by doing this.

However, not doing that allows me to write this instructional article on how to read their backtester, because almost everyone I interact with is doing it wrong.

So sit down, open up your favorite symphony, and follow along.

Lets go with a variant of TQ3 FTLT cause its the building block for so much of what the community invests in. We’re going to be breaking this down in to steps.

1. Max the length of your backtest.

In the example given above, set it to May 31st, 2011. Nice, long, 12 year backtest. This is going to give us the most time to dig around in and play with.

2. Note the max drawdown.

%54.4, thats pretty sizeable. Noted, lets continue.

3. Zoom the viewing window down to 1-3 months.

Its going to look something like the above graph. Check the -40% drawdown! All the way out, you don’t even see that on the graph, but I bet your stomach would be hurting around the -20% mark!

4. Slide the viewing window along, very slowly.

Keep going. Note the number of times you see a drawdown number that makes you uncomfortable. Keep sliding the window until you get to the present day. Think about all the ups and downs, gains and losses, painful drawdowns and faceripping rallies you just saw in that test.

5. Reflect on your risk tolerances

Can you handle the amount of 10%+ drawdowns you just saw in your symphony of choice? How about the 20% ones? 30%? How many of each were there?

If your answer to any of those questions is “no”, you may want to reconsider running whatever strategy you’re looking at. The worst possible way you can handle this is by trying to deal with it, failing, and hopping out at the bottom. You’ll either get out and go back to “VTI and chill,” which is honestly fine, or in to another strategy that’ll inevitably do the same thing to you eventually.

6. Read the logic of the strategy. Then read it again.

I don’t just mean read the logic, dig in to it. Figure out why the logic is what it is. Why is the RSI trigger for QQQ set at 81 instead of 80? What does the 60 day cumulative return of BIL being higher than the 60DCR of BND mean, and does the assets under that trigger make sense in those situations?

If you don’t understand why your strategies do the things they do, watching them go in to the red is INFINITELY HARDER than being confident in your knowledge and your creation. If your strategy isn’t your creation, don’t run it until you understand it like its creator. Full stop, no exceptions.

7. Internalize all of the above information you just gathered,

Come to terms with the drawdowns. Learn to love them. It isn’t the green days that’ll make you change your mind about things, I promise you that. The faster you steel your mind against worry when you see a month of red, the faster you’ll be on the path to not losing all your money.

There we have it folks.

The big takeaway from all this is not a technical lesson, even if the tools are useful. It is instead a psychological one. Give yourself the information needed to remain calm in the face of adversity and troubles. You’ll be better off for it, and your portfolio will thank you. Maybe you’ll even learn something in the process!

Now, go enjoy the coverage of the run up to Jackson Hole and JPow.

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