Question

You are backtesting a promising-looking trading strategy. To decide whether it is good, it's best to compare the return it generates to:

O Cash in mattress
O Buy and hold return on the underlying asset class
O Return on a broad market index
O Treasury bill yield

Answer 1

When backtesting a trading strategy, the return should be compared to the return on a broad market index for a comprehensive and contextual performance evaluation. This comparison helps to determine if the strategy offers an advantage over general market movements and accounts for different risk levels.

Step-by-step explanation:

When backtesting a trading strategy, it is most beneficial to compare the return it generates to the return on a broad market index. This approach provides a benchmark that reflects market conditions over the testing period and allows for a comprehensive evaluation of the strategy's performance in relation to the overall market.

The tradeoff between return and risk is crucial in making investment decisions. A strategy that outperforms a broad market index suggests that it may offer an advantage, while underperformance could indicate higher risk without commensurate returns. Additionally, comparing to a broad market index rather than the buy and hold return on the underlying asset class can account for market-wide fluctuations and sector-specific risks.

On the other hand, cash in a mattress provides no return and therefore is not a credible benchmark, and the Treasury bill yield represents a risk-free rate which might be too conservative when evaluating strategies that involve taking on additional market risk.