12 – M4 L3a 11 Universe Construction Rule V3

One important thing to note is that when we say “universe”, we really mean Universe Construction Rule. Meaning, we cannot pick a static list of stocks and just use those for all time periods historically. If we chose a static list of stocks that exists today, or that have data for the time window of interests, that would include look-ahead bias. Look-ahead bias occurs when we simulate a trade on historical data using information that wouldn’t be known at that time. A particular kind of look-ahead bias is survivorship bias. Survivorship bias occurs when we have the benefit today of choosing stocks for the past. In order to have an unbiased sample for our stock universe, we would not want to exclude companies that, for example, went bankrupt or were acquired because in the past, we would not know about those future events. Instead, we have to use a rule that creates the universe as it would have been for each day. One way to do this is to use a commercial index provider and use the components of an index as they were historically. That’s actually what we do here. We’re using the S&P 500 index. The S&P 500 is an index that’s managed by Standard and Poor’s. They managed index, adds, and deletes. By choosing our stock universe to include the stocks when they’re in the index and exclude them when they are no longer in the index, we can more faithfully simulate a portfolio that would have existed in that point in time, thereby reducing look-ahead bias.

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