RT Journal Article
SR Electronic
T1 The Deflated Sharpe Ratio: <em>Correcting for Selection Bias, Backtest</em>
               <br/>
               <em>Overfitting, and Non-Normality</em>
JF The Journal of Portfolio Management
FD Institutional Investor Journals
SP 94
OP 107
DO 10.3905/jpm.2014.40.5.094
VO 40
IS 5
A1 David H. Bailey
A1 Marcos López de Prado
YR 2014
UL https://pm-research.com/content/40/5/94.abstract
AB With the advent in recent years of large financial data sets, machine learning, and high-performance computing, analysts can back test millions (if not billions) of alternative investment strategies. Backtest optimizers search for combinations of parameters that maximize the simulated historical performance of a strategy, leading to back test overfitting. The problem of performance inflation extends beyond back testing. More generally, researchers and investment managers tend to report only positive outcomes, a phenomenon known as selection bias. Not controlling for the number of trials involved in a particular discovery leads to overly optimistic performance expectations. The deflated Sharpe ratio (DSR) corrects for two leading sources of performance inflation: Selection bias under multiple testing and non-normally distributed returns. In doing so, DSR helps separate legitimate empirical findings from statistical flukes.TOPICS: Big data/machine learning, factor-based models, statistical methods