7

Playing Simulation Games

So far, we have used only historical market data to analyze the strengths, weaknesses, and returns of various formula strategies. This fact instills in many people a certain confidence, in that these strategies have worked in actual market conditions we all have lived through. But analyses using only historical data may give investors a false sense of security. This chapter, therefore, explains a different but complementary approach—market simulations1—for analyzing possible outcomes and typical performance of various investment strategies.

WHY SIMULATIONS?

In the past, many possible future outcomes existed for the stock market. Much like today, no one in 1926 knew what the market would do in the next year. In retrospect, we have seen what actually happened, but that was just one of an infinite number of possible market histories. Think of the return on the market as being random, like a roll of the dice.2 If you rolled the dice yesterday and an 11 came up, would you really base your future betting strategy on that same 11 coming up again next time?

Like the roll of the dice, the market return in any given future period is uncertain. So, what's the danger in using only historical data to test various investment strategies? After all, it's reassuring to know how a particular strategy worked in the past. But under an even slightly different future scenario, the results might differ substantially. In fact, lots of ways to supposedly “beat the market” can ...

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