Backtest overfitting and the post-hoc probability fallacy

13-card hand dealt “at random”

Introduction

In several articles on this site (see, for instance, A and B), we have commented on the dangers of backtest overfitting in finance.

By backtest overfitting, we mean the usage of historical market data to develop an investment model, strategy or fund, where many variations are tried on the same fixed dataset. Backtest overfitting, a form of selection bias under multiple testing, has long plagued the field of finance and is now thought to be the leading reason why investments that look great when designed often disappoint when actually fielded to investors.

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