If you’re looking to maximize investment returns, perhaps you should think like a gambler. The Kelly criterion was used by horse racing gamblers in the late 1950s. Today, Warren Buffet and others use it for investing purposes. Before addressing your investment strategy, learn about the Kelly criterion and see if it’s a fit for you.
What Is the Kelly Criterion?
The Kelly criterion was formulated by John Kelly while he was working at AT&T’s Bell Laboratories. He used it to help with long-distance telephone signal issues. Once published it 1956, it became popular with gamblers. They saw it as a betting system to increase their returns, which led to its other names: the Kelly strategy or Kelly bet.
However, it’s also used among investors. It can show how much a trade yields in possible returns. The components are:
K% = W — (1 — W) / R
K% = percentage of capital to put into a trade
W = Winning probability
R= Win/loss ratio
The formula might be popular among gamblers, but investors utilize it for asset allocation and money management.
How to Use the Kelly Criterion
To calculate the “W,” divide the number of trades that brought in a positive amount by your total number of trades. The closer to 1 you get, the better.
To calculate the “R,” divide the average gain of positive trades by the average loss of negative trades. If the positive trades are better than the negative ones, your number should be greater than one.
Input these figures into the equation to see your results. The percentage you get as a result is how much you should invest. If your result is 0.10, that means you should invest 10% of each of the equities in your portfolio. It’s a quick way to show you how much you should invest in a particular security to diversify your portfolio.
Does the Kelly Criterion Work?
Remember that Kelly developed this formula while improving long-distance telephone signals. As an accidental investment formula, it might work for you. However, keep a few things in mind.
- It’s not a predictor. Like the stock market, it’s hard to know how certain stocks and securities will perform over the course of the next week, month, and year. While some formulas like the Kelly criterion may give you an idea of if a stock is worthy of investing, you can’t fault it if (and when) things don’t always go your way.
- It needs solid figures. Considering it’s a mathematical equation, you can’t choose your numbers based on what you think they are. If you don’t have the most accurate figures to input, you won’t get accurate results.
- It showcases diversification. At the very least, you should be able to see how much (or little) a trade should get through your investments. As a general rule of thumb, don’t put all your eggs into one basket, and keep many different types of investments in your portfolio. Avoid investing more than 20% to 25% of your money into any one stock or security, even if the Kelly formula tells you otherwise.
The Bottom Line
Even though it worked for the gamblers doesn’t necessarily mean the Kelly criterion will work for you. While it’s good to use many different money management formulas, don’t rely on only one type to get an idea of good and bad investment choices.
The Kelly criterion can be a good option to see how a potential investment could bode for your overall portfolio. It can give you an idea of how much — or how little — to invest in a particular security. But it doesn’t mean you should put all your money towards one trade. Even if the model gives you a high percentage as an answer, it’s a good idea to have many different securities and investments, not just a few.
Money Management Tips
- Getting expert advice might be more meaningful than what a formula tells you to do. If you’re unsure about where to park your cash, it could be time to talk to a professional. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now. Talking to a human that understands your investment preferences and lifestyle might yield better results than using a formula like the Kelly criterion.
- The Kelly criterion is one model of investment money management, but it’s not the only one. Use SmartAsset’s asset allocation calculator to match up your allocations with your risk tolerance. The Kelly criterion doesn’t take your risk tolerance, age, or any investment style into consideration, which might be important for you to determine if a stock is worth jumping on.
Photo credit: ©iStock.com/utah778, ©iStock.com/PeopleImages, ©iStock.com/utah778