But what share of the portfolio should it take up? Too small an allocation and the portfolio will lose out on growth. It’s clearly a good investment, with a positive expectation: E(x) = 60% * 20 + 40% * (-20%) = 4%. No other outcomes are possible, and the investment can be repeated across many simulations, or periods. The top article in a Google search for “Kelly calculator equity” presents a simple, stylized investment with a 60% chance of gaining and a 40% chance of losing 20% in each simulation. Unfortunately, most of the sources I found use the wrong formula. I learn by example and my math is rusty, so I looked for a short, non-technical article about how the formula can work in an equity-like investment. While the Kelly formula requires an estimate of the probability distribution of investment outcomes ahead of time, i.e., a crystal ball, its mainstream alternative, Harry Markowitz’s mean/variance optimization, calls for an estimate of the covariance matrix, which for a bottom-up investor, I believe is much more difficult to obtain.Īfter reading Poundstone’s book, I wanted to apply the Kelly criterion to my own investing. In my view, the formula is consistent with the value investing concept of a margin of safety and leads to concentrated portfolios in which the dominant ideas have the greatest edge and smallest downside.ĭespite its relative obscurity and lack of mainstream academic support, the Kelly criterion has attracted some of the best-known investors on the planet, Warren Buffett, Charlie Munger, Mohnish Pabrai, and Bill Gross, among them. It is the only formula I’ve seen that comes with a mathematical proof explaining why it can deliver higher long-term returns than any alternative. I came across it almost by accident, in William Poundstone’s delightful book Fortune’s Formula.Ĭreated in 1956 by John Kelly, a Bell Labs scientist, the Kelly criterion is a formula for sizing bets or investments from which the investor expects a positive return.
#Kelly paper drivers
Posted In: Drivers of Value, Economics, Equity Investments, Portfolio Managementĭespite expending substantial resources on a formal financial education, I did not encounter the Kelly criterion in business school or the CFA curriculum.
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