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
The purpose of the Kelly criterion in investing is to see how much money you should put into a single trade.
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.
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
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