Backtesting is comforting because it feels scientific, but dangerous because it assumes continuity. Often, clients ask if the allocation we’ve put together for them is “the best historically…and that’s why Root chose it?”
In fact, it is not. “The best historically” would involve running the numbers, turning the dials to perfectly align Sharpe ratio, alpha, and risk-adjusted return, then coming up with very precise allocation percentages that must be adhered to. All for what? To perfectly engineer the portfolio that would have done best over the last 20 years. Great! Glad we’re doing that now!
No. No, that’s not what we do. And the problem is not a lack of data; it’s that humans are wired to extrapolate the recent past and engage in all kinds of self-sabotaging behavior to fit that past into the future. Among them:
- Recency bias: we overweight what just happened
- Narrative fallacy: we confuse something mildly plausible with the truth
- Action bias: we do something because doing something feels safer than staying put
Let’s take one example of what an investor may hear as they go out and interview a handful of wealth management firms—this, describing the investment strategy:
“We look at the trailing three years, combine that with a fundamental understanding of the economic headwinds and tailwinds for the U.S., developed markets, and emerging markets, then layer a proprietary momentum and quality calculation on top. The combination of these variables determines our allocation changes for the following year. This has delivered outstanding results [in the backtested simulations].”
Now consider the bar chart below, which compares relative calendar-year returns of U.S. and ex-U.S. markets from 1987–2025. Gold represents U.S. underperformance, and green represents U.S. outperformance.
The firm above, in layman’s terms, bases its allocation decisions (at least for U.S. and ex-U.S. exposure) on the optimal portfolio for the last one, three, and five years. So, using this narrow example, when they go to adjust the portfolio that has historically delivered the best mix of risk and return, they’d likely:
- 1989 — Overweight International
- 1992 — Overweight U.S.
- 1995 — Overweight International
- 1999 — Overweight U.S.
- And so on…
If the pattern isn’t obvious, as soon as you begin overweighting a particular market segment because it is “historically optimal,” performance frequently goes the other way. This may seem simplistic, but it’s emblematic of why the average investor underperforms the very investments they hold by a wide margin.
Backtesting optimizes for one specific past. Real portfolios must survive many possible futures. The more precisely a strategy is engineered to the past, the more fragile it becomes to the future.
So, No Backtesting?
Of course we use historical data to guide our portfolio construction decisions. We also combine that with first-principles thinking, behavioral considerations, tax planning, and the current state of financial markets. All of this comes together to form an investment philosophy, which is then expressed in the allocations we build for clients…not because they are necessarily optimal, but because we believe they are capable and flexible enough to handle the uncertainty markets present and the changes people experience as they figure out what getting the most out of life looks like for them.
The quest to engineer the perfect portfolio is never-ending. But if the future is unknowable, how can we kid ourselves into believing the past can be perfectly optimized to address it?
CONSIDER
“If you don’t read books, you live one lifetime. If you read books, you live 1,000 lifetimes.
Books are the closest thing you’ll ever come to finding cheat codes for real life. You can access the entire learnings of someone else’s career in a few hours.”
— Tobi Lütke, Founder of Shopify
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Let’s get after it this week!
Brooks
Brooks Palmer, CFP® is Head of Investments at Root where he helps identify, evaluate, and implement investment solutions tailored to clients’ needs. In Full-Court Press, he breaks down what’s happening in the markets—cutting through the noise and jargon—while connecting it to Root’s core investment tenets so you can make the most of your money and your life!
Illustrations and index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results.
The examples provided are hypothetical and for illustrative purposes only. The information presented should not be construed as investment advice or a recommendation to buy or sell any security or implement a particular strategy.
Advisory services are offered through Root Financial Partners, LLC, an SEC registered investment adviser.