Data-driven investing uses systematic,

quantitative strategies to analyze current and

historical data to forecast securities' future
performance. It departs from conventional
methods that often rely on intuition,
qualitative analysis, or historical precedence.
Educational Use-Only Financial Modeling by Pedro C. Souto Version 3.0

FINANCIAL
MODELING
MASTERS COURSE 2023-2024
The adage "Past performance is not
indicative of future results" remains a
standard warning in the financial sector. Yet,
a methodical review of past performance,
or backtesting, is critical to understand and
potentially forecast a strategy's viability.
 Variable
User interface (UI)
Model assumptions Output
Overview

Fixed
assumptions Engine

DATA
Models may have complex calculations, but they always have simple user interfaces
Detailed Mechanics of Modeling
Data Collection:

a. Sources: From direct market feeds, databases like Bloomberg, Quandl, or free sources
like Yahoo Finance.
b. Types of Data: High-frequency intraday data, daily closing prices, fundamentals,
sentiment data, and more.
c. Data Cleaning: Address missing values, outliers, and adjust for splits or dividends.
Detailed Mechanics of Modeling
Strategy Definition:

a. Trade Criteria: Define specific conditions for entering and exiting trades.
b. Portfolio and Capital Allocation: Decide on how much capital to assign to each trade
or asset.
c. Risk Management Rules: Set stop losses, take profit levels, and other protective
measures.
Detailed Mechanics of Modeling
Implementation:

a. Coding the Strategy: Using platforms or languages like Python, C++, or specialized software
like QuantConnect.
b. Simulation: Run the strategy against the historical data, mimicking the conditions of live
trading.

Performance Analysis:

c. Benchmarking: Compare the strategy's performance against relevant benchmarks like the
S&P 500.
d. Risk Metrics: Understand potential drawdowns, volatility, and other risks relative to returns.
The Essence of Modeling Testing
a. Testing Asset Returns:
i. Example: Testing whether the average return of a particular stock is different from zero.
b. Evaluating Investment Strategies:
i. Example: Determining if a new trading strategy outperforms the market average.
c. Cointegration Tests:
i. Used to verify if pairs of securities move together over time, which is vital for pairs
trading strategies.
d. Event Studies:
i. Analyzing the effect of specific events, like mergers or earnings announcements, on
stock prices.
Challenges & Considerations in Testing
a. Data Snooping: The misuse of data mining techniques, which can lead to false
discoveries.
b. Non-Normal Distributions: Financial returns often don't follow a normal distribution,
which can impact certain tests.
c. Multiple Testing Problem: Conducting many hypothesis tests simultaneously
increases the chance of finding at least one statistically significant result by chance.
d. Model Assumptions: Assumptions (e.g., equal variance) might not always hold,
leading to misleading results.
Benefits of Modeling: A Deeper Insight
a. Confidence Building: A well-tested strategy can increase trader's confidence in its
real-world application.
b. Strategy Evolution: Over time, as market dynamics change, backtesting can help in
refining and evolving strategies.
c. Capital Allocation Guidance: Helps determine how much capital to allocate to a
strategy in the larger portfolio context.
Pitfalls and Considerations: Beyond the Basics
a. Parameter Sensitivity: How do slight changes to strategy parameters affect its
performance? Over-optimization can lead to a strategy that works only for a specific
set of parameters.
b. Market Regime Changes: Financial markets evolve, and strategies might not account
for unforeseen structural changes or black swan events.
c. Post-Strategy Drift: The danger of deviating from a backtested strategy once it's live
due to emotions or external advice.
d. Adaptive Markets: Markets adapt to widely-adopted strategies, making them less
effective over time.
Advanced Best Practices
a. Walk-Forward Analysis: A dynamic form of out-of-sample testing where the
optimization step is periodically re-run and tested on new unseen data.
b. Monte Carlo Simulations: Provides a range of possible outcomes and the probabilities
they will occur for any choice of action.
c. Stress Testing: Subjecting the strategy to extreme but plausible adverse conditions to
understand potential vulnerabilities.
Modeling, while immensely valuable, is a
double-edged sword. When done
meticulously and interpreted with caution,
it can be the cornerstone of successful
quantitative trading. However, over-reliance
without understanding its complexities can
lead to unexpected pitfalls.
Educational Use-Only Financial Modeling by Pedro C. Souto Version 3.0

FINANCIAL
MODELING
MASTERS COURSE 2023-2024